IRS QSBS Rules: What California and Washington Families With Startup Equity Need to Know

By Kevin Luu, Co-Founder and Chief Learning Officer. Reviewed on 2026-09-30.

Under the IRS QSBS rules in Internal Revenue Code Section 1202, you can exclude federal tax on gain from selling stock in a qualifying US C corporation if you got the shares directly from the company and held them long enough. For stock acquired after July 4, 2025, the exclusion is 50% after 3 years, 75% after 4 years and 100% after 5 years, capped at the greater of $15,000,000 or 10 times your basis per company. California does not follow these rules, so California residents generally still owe state tax on the full gain.

For a family where one parent works at a pre-IPO startup in the Bay Area or Seattle, QSBS can be the single largest tax item they ever face. It is also easy to lose through a timing mistake.

Who actually has QSBS in a high-income W-2 household

Most stock compensation is not QSBS. Shares of Apple, Amazon, Microsoft, Gilead or Genentech’s parent are not eligible, because those companies were far past the size limit when they issued your shares. QSBS shows up when a parent:

• Exercised stock options at a startup that is a domestic C corporation (the holding period starts on the exercise date, not the grant date).
• Received restricted stock and filed an 83(b) election, or early-exercised options and filed one (the holding period starts at the transfer).
• Received shares from RSUs at a qualifying startup (shares delivered at vest can count, because Section 1202 covers stock received “as compensation for services”; the holding period starts at delivery).
• Invested cash directly in a company’s priced round, as an angel or through a friends-and-family round.

Unvested options and RSUs are not stock yet. The QSBS clock has not started for them.

The five tests your shares must pass

The company, not you, controls most of these facts. Ask the startup’s finance team for a written QSBS representation, and keep it with your option exercise records.

What changed in 2025, and which rules apply to your shares

The 2025 federal tax law (P.L. 119-21, Section 70431) split QSBS into two regimes based on when you acquired each lot:

• Acquired on or before July 4, 2025: you must hold more than 5 years. Stock acquired after September 27, 2010 gets a 100% exclusion once that test is met. The per-company cap is $10,000,000 or 10 times basis.
• Acquired after July 4, 2025: 50% exclusion at 3 years, 75% at 4 years, 100% at 5 years. The cap is $15,000,000 or 10 times basis, indexed for inflation after 2026. The gross-asset limit rose to $75,000,000.

Many employees hold both kinds of lots in the same company. Each exercise date is its own lot with its own clock.

Worked example: a California family with a 2022 option exercise

Assumptions: a married couple in Palo Alto filing jointly with $950,000 of W-2 income a year. One parent exercised startup options in January 2022 for $40,000. The company agrees to be acquired, the closing could land in December 2026 or February 2027, and their shares are worth $6,040,000, a $6,000,000 long-term gain. The stock meets every QSBS test. Federal rates are the 2026 rates; California rates are 2025 rates, because the FTB has not published 2026 schedules.

At their income, the gain sits in the top federal capital gains bracket (20% applies above $613,700 of taxable income for joint filers in 2026), and the 3.8% Net Investment Income Tax applies above $250,000 of MAGI. For this pre-July 2025 stock there is no partial exclusion: one month short of five years means no federal exclusion at all. If an acquirer offers a choice of closing dates, the date matters a great deal.

California is the other half of the story. The FTB lists QSBS among the federal changes California does not adopt, and California has no lower rate for capital gains. Most of this gain falls in the 12.3% bracket plus the 1% Behavioral Health Services Tax on taxable income over $1,000,000.

Worked example: stacking the cap for a Washington family

The cap applies per taxpayer, and Section 1202(h) lets someone who receives QSBS as a gift keep the original acquisition date and QSBS status. That is the basis for “stacking”: giving shares to other taxpayers, usually non-grantor trusts for children, so each holder has its own cap.

Assumptions: a Seattle couple with two children, ages 4 and 7. One parent exercised options at a qualifying startup in October 2025 for $150,000, so 10 times basis is $1,500,000 and the $15,000,000 figure is the cap that matters. In 2026, an independent appraisal values the shares at $2,000,000. They expect a sale in 2031 for a total gain of about $40,000,000 (rounded, basis ignored).

• No planning: $15,000,000 is excluded and about $25,000,000 is taxable federally. At 23.8%, that is about $5,950,000.
• With stacking: in 2026 they give a quarter of the shares to a separate non-grantor trust for each child. Each gift is valued at about $500,000, reported on Form 709, and uses a small part of each parent’s $15,000,000 lifetime exclusion. At the sale, each trust has about $10,000,000 of gain, under its own $15,000,000 cap. The parents keep half, about $20,000,000 of gain, so $5,000,000 is taxable. Federal tax: about $1,190,000.

The difference is about $4,760,000 of federal tax, and the trusts’ value sits outside the parents’ estates. That second point matters in Washington, where the state estate tax exclusion is $3,000,000 for deaths from July 1, 2026, far below the federal $15,000,000.

Washington has no wage income tax in 2026, but it does tax long-term capital gains at 7%, and 9.9% above $1,000,000 of taxable gains. The state’s tax starts from federal net long-term capital gain as defined in RCW 82.87.020, which does not list Section 1202 among the federal provisions it ignores. That suggests gain excluded federally stays out of the Washington base, but confirm it with your CPA before a sale. Washington also adds a 9.9% income tax on AGI over $1,000,000 starting in 2028, and how that tax treats QSBS gain is not yet defined.

Common mistakes that cost the exclusion

1. Gifting to a grantor trust and expecting a new cap. A grantor trust is generally treated as you for income tax, so most practitioners do not count it as a separate taxpayer for stacking. Stacking trusts are usually non-grantor trusts, which have their own tax return and trustee.
2. Gifting after a term sheet arrives. The gift is valued when made. Waiting until an acquisition is likely makes the gift larger and invites questions about whether the gain was already fixed.
3. Assuming a holding period starts at grant. For options it starts when you exercise. Early exercise with an 83(b) election can start it sooner, but you pay the exercise price up front and take the risk.
4. Losing records. Proving QSBS years later needs the exercise confirmation, the company’s capitalization and gross-asset history, and any 83(b) filing. Startups get acquired and their records go with them.
5. Ignoring California. A Bay Area family that plans only around the federal exclusion can still face a state bill in the hundreds of thousands of dollars on a large exit.

The decision your family actually has to make

For most families with startup equity, the questions are short:

• Do we know which of our lots are QSBS, when each one hits 3, 4 and 5 years, and what the company says about its gross assets?
• If the company could plausibly be worth more than the cap for us, do we want to move shares to trusts for the children now, while the value is low?
• If we live in California, are we comfortable carrying the state tax, or would a sale timed around a planned move be realistic? (A move made for tax reasons alone rarely works for families with young children in local schools.)
• How does this exit fit with the concentration risk we already carry in one employer?

Our tax management and estate planning work at Age Five Family Office™ starts with a lot-by-lot map of this kind. The concentration question belongs with investment risk management.

What to write down for your children

If you set up trusts for your kids, they will one day own a large sum that came from a single decision. Write a one-page Decision Memo: why you chose to fund their trusts, what you hoped the money would and would not be used for, and what you would have done if the company had failed. File it in your FamilyKnowledge® Library with the trust documents. As Kevin Luu puts it: “Your kids don’t need to inherit your portfolio. They need to inherit your decision-making process.” Our family governance work covers how to structure that record.

Frequently asked questions

Does QSBS apply to California state taxes?

No. California does not conform to Section 1202 or the 2025 expansion, so a California resident generally reports the full gain as income on the state return. Federal tax can still be zero. Families who expect a large exit sometimes look at where they will live at the time of the sale, but residency rules are strict and a move needs to be real, not paper.

Can RSUs from a startup qualify as QSBS?

They can, if the company meets every test when the shares are delivered. Shares received for services count as original issuance. The holding period starts when the shares are delivered at vest, not when the RSUs were granted. RSUs from a public company like Apple or Amazon do not qualify, because those companies exceed the gross-asset limit.

Does gifting QSBS to a child reset the holding period?

No. Under Section 1202(h), a person who receives QSBS by gift is treated as acquiring it the same way and on the same date as the giver. A gift to a child’s custodial account or trust keeps the clock running. See our guide to UTMA withdrawal tax rules before using a custodial account for large gifts.

Next step

Pull your option exercise confirmations and list every lot with its acquisition date and price. That list tells you when each lot crosses 3, 4 and 5 years and whether stacking is worth discussing. If you want a second set of eyes, a Tax & Wealth Assessment walks through it with you.

This is general education, not individual tax advice. The right move depends on your family’s full picture, and QSBS planning should be confirmed with your CPA and estate attorney.

Written by

Kevin Luu

Co-Founder and Chief Learning Officer, Bright Advisers

Kevin has advised high-income W-2 tech and biotech families since 2015, and leads the education-first Age Five Family Office from Brea, California.

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