Request a Consult | 703-553-1099
Listen to the Audio Overview
For entrepreneurs, founders, and angel investors, the U.S. tax code offers powerful incentives designed to encourage investment in startups and small businesses.
If you are building or investing in a company, three provisions are particularly important to understand: Section 1202 Qualified Small Business Stock (QSBS), Section 1244 loss deductions, and the Research & Development (R&D) tax credit.
Each provides a different type of tax advantage. The R&D tax credit can help offset the cost of innovation as businesses develop new products, improve existing technologies, or refine internal processes. Section 1244 may allow founders and investors to deduct certain startup losses as ordinary income if a venture fails. And QSBS can allow qualifying shareholders to exclude a significant portion of capital gains when they sell stock in a successful startup.
Understanding how these incentives work and structuring a business early to take advantage of them can make a meaningful difference in the long-term tax outcomes for founders and investors.
Qualified Small Business Stock (QSBS), established under Section 1202 of the tax code, is one of the most powerful tax incentives available to founders and early investors in high-growth startups. For qualifying stock acquired after July 4, 2025, shareholders may be able to exclude up to $15 million in federal capital gains, or 10 times their investment basis if greater, when they sell stock in a qualifying company.
The provision was designed to encourage early investment in emerging companies that often require years of capital and carry significant risk before becoming profitable. QSBS can provide a meaningful tax benefit if the company ultimately succeeds.
For example, a founder who receives stock when a startup is formed might initially hold shares worth $50,000. If the company is later acquired and those shares are worth $8 million, the founder would normally owe federal capital gains tax on nearly the entire $7.95 million gain.
If the shares qualify as QSBS, the founder may be able to exclude the entire $7.95 million gain from federal capital gains tax. Many states follow the federal treatment as well, although some states, such as California and Pennsylvania, do not recognize the exclusion, making it important to review your state’s rules or consult a tax professional when evaluating potential QSBS benefits.
QSBS applies only in specific situations. The stock must be issued by a C-corporation, and the company’s gross assets generally must not exceed $75 million at the time the stock is issued. While the most favorable tax treatment still applies when shares are held for five years or more, recent legislation introduced partial gain exclusions for shorter holding periods — generally 50% after three years and 75% after four years. In addition, some industries, including many professional service businesses such as law, accounting, consulting, financial services, and healthcare practices, are not eligible.
Recent legislative changes have also expanded several tax incentives designed to support startup investment and innovation. These updates were included in the One Big Beautiful Bill Act (OBBBA), which introduced several tax law changes affecting entrepreneurs and business owners. We covered those changes in more detail in our article, “Tax Law Changes Under the One Big Beautiful Bill Act (2025 and Beyond).”
Because QSBS eligibility depends heavily on how a company is structured and when stock is issued, planning early in a company’s lifecycle is critical. A knowledgeable tax advisor can help founders and investors structure ownership and financing decisions in ways that preserve potential QSBS benefits. Founders and investors who wait until a potential sale is on the horizon may discover that the opportunity to benefit from QSBS has already passed.
While QSBS provides a significant tax advantage when a startup succeeds, Section 1244 offers potential tax relief if a venture does not work out as planned.
Under normal tax rules, losses from stock investments are treated as capital losses, which generally allow taxpayers to deduct only $3,000 per year against ordinary income unless they have capital gains to offset. Section 1244 can provide more favorable treatment by allowing certain qualifying stock losses to be treated as ordinary losses instead of capital losses, permitting deductions of up to $50,000 per year, or $100,000 for married couples filing jointly, against ordinary income.
For example, an investor who contributes $40,000 to a qualifying corporation and later loses that investment when the business fails might normally be limited to deducting only $3,000 per year as a capital loss. At that rate, it could take more than a decade to fully deduct the loss against ordinary income if no capital gains are available.
If the stock qualifies under Section 1244, however, the investor may be able to deduct the entire $40,000 loss in the year the stock becomes worthless, subject to the applicable limits.
Like QSBS, Section 1244 applies only under specific conditions. The stock must be issued by a U.S. small business corporation (either a C-corporation or an S-corporation) and acquired directly from the company in exchange for money or property. In addition, the corporation generally must have had total capital of no more than $1 million at the time the stock was issued, making it important to plan ahead when structuring the company and issuing stock to founders or early investors.
While QSBS and Section 1244 focus on the tax outcomes of startup investments, the Research & Development (R&D) tax credit helps offset the cost of innovation while a business is still building and growing.
Created under Section 41 of the tax code, the R&D tax credit provides a dollar-for-dollar reduction in tax liability for certain qualified research activities. Despite its name, the credit is not limited to companies operating in laboratories or developing cutting-edge technology. Many everyday business activities may qualify.
Examples of qualifying activities can include developing new products, improving manufacturing processes, creating or refining software, or solving technical challenges in areas such as engineering, food production, or industrial design. Wages paid to employees involved in these activities, supplies used during testing, and certain contract research costs may all be eligible expenses.
Recent legislative changes have also improved the tax treatment of research expenses. The One Big Beautiful Bill Act restored the ability for businesses to immediately deduct domestic R&D expenses beginning in the 2025 tax year, reversing a rule that previously required companies to spread those deductions over several years. For a deeper explanation of these changes and the planning opportunities they create, see our article, “2025 R&D Tax Credit Updates Under the One Big Beautiful Bill Act.”
QSBS, Section 1244, and the R&D tax credit are all designed to support business funding at different stages of the startup journey. Yet many founders and early investors may not be aware of these provisions when launching a company, or how important early planning can be.
The R&D tax credit can help offset the cost of innovation while a company develops products and improves processes. Section 1244 may provide meaningful tax relief if a venture does not succeed. Section 1202 Qualified Small Business Stock (QSBS) can offer significant capital gains exclusions when a startup ultimately achieves a successful exit.
Because each of these incentives depends on how a business is structured, how stock is issued, and how activities are documented, tax planning early in a company’s life is essential. Founders and investors who understand these rules from the beginning are often better positioned to take advantage of them as their businesses grow.
If you are launching a company, bringing on investors, or investing in a startup, the team at Wendroff & Associates can help you evaluate these opportunities as part of your overall tax strategy. Use the Free Consultation button below to schedule a meeting.
