States Are the New QSBS Battleground
For years, Qualified Small Business Stock (QSBS) has been one of the most important federal policies supporting startup growth and early-stage investment. While recent changes at the federal level have made it easier for more startup founders, early employees, and investors to benefit from this tax treatment, many states are trying to limit those benefits, inadvertently curtailing startup activity, investment, and economic growth in their states.
Thanks to QSBS, found in Section 1202 of the tax code, eligible investors, founders, and early stage employees can exclude certain gains from the sale of qualified startup stock, helping offset the considerable risk that comes with investing funds as well as time and energy in early-stage companies. Startups leverage the favorable treatment of QSBS to attract investors and create more competitive compensation offers for vital talent. Startups can offer stock in their company to both investors and early employees, and as long as the investor or employee holds that stock for a certain amount of time, they can avoid being taxed when selling the stock. The One Big Beautiful Bill Act (OBBBA), passed in 2025, makes the QSBS exclusions permanent and allows the exclusions to kick in after three years (50 percent), four years (75 percent), or five years (100 percent). The cap on qualifying stock value was raised from $10 million to $15 million, boosting an already valuable tool startups use to attract top talent and potential investors.
But over the last two years, rather than creating additional startup incentives, some state lawmakers are instead working to tax the gains excluded under federal QSBS at the state level. If this trend gains more traction, founders and investors could face a growing patchwork of state tax treatment that weakens one of the country’s most effective startup incentives.
States already decoupled from federal QSBS treatment: California, Mississippi, Alabama, and Pennsylvania
To begin with, not every state currently conforms to the federal treatment of QSBS. California, Alabama, Mississippi, and Pennsylvania tax gains that are excluded under federal QSBS rules, meaning founders, employees, and investors in those states may still face state-level capital gains taxes on otherwise federally exempt QSBS earnings.
California is perhaps the most notable example given its outsized role in the startup ecosystem. In 1993, California enacted legislation preventing the state from conforming with Section 1202 of the federal tax code (QSBS). For a period of time, the state did allow a partial QSBS exclusion, but that treatment was ultimately struck down by the California Supreme Court. Today, QSBS gains remain fully taxable at the state level in California, where the top capital gains rate reaches 13.3 percent. California’s posture is likely balanced out by the state’s existing advantages: access to venture capital, deep talent networks, established startup infrastructure, and home to major tech companies. However, smaller and emerging startup ecosystems may not be similarly positioned to offset the impact of less favorable tax treatment. For states still trying to attract early-stage investors and companies, conforming to QSBS may become increasingly important in the interstate competition for innovators.
States considering QSBS decoupling
Following the federal expansion of QSBS through OBBBA, several states reconsidered whether they should continue conforming to the federal exclusion. In many cases, the state lawmakers championing decoupling have the incomplete view that it is merely a tax break for the wealthy and the expansion will result in lost state tax revenue, particularly as many states face growing budget pressures.
Oregon recently became the clearest proponent of this trend. In 2026, the state enacted SB 1507, requiring taxpayers to add back gains excluded under federal QSBS rules when calculating Oregon taxable income. Supporters saw the bill as a tax revenue preservation measure while critics warned that in the long term this move would weaken incentives for startup investment and entrepreneurship within the state.
New York and Washington have also explored similar proposals. Legislation introduced in New York would require taxpayers to add federally excluded QSBS gains back into state taxable income, signaling growing interest in treating QSBS less as a startup incentive and more as a forgone source of state revenue. Washington lawmakers similarly considered legislation that would subject QSBS gains to the state’s capital gains tax structure. While neither proposal has been enacted, both demonstrate that state-level QSBS conformity is becoming an increasing debate in state legislatures.
Notably, this debate is also playing out in D.C., where the Council passed temporary QSBS decoupling legislation in December 2025, Congress moved to block it and now the issue will be considered again by the D.C. Council as part of their FY2027 budget.
States strengthening or benefiting from QSBS-friendly tax environments
The majority of states fully conform with Section 1202, meaning states directly follow the federal QSBS rules for state tax treatment. Other states have conformed by effectively creating even more favorable environments for startup investment. Nine states currently have no state income tax or capital gains tax which means qualifying QSBS gains in those states avoid both federal and state taxation, while creating a comparatively favorable tax environment for startup investors and founders.
New Jersey recently moved even further in the pro-startup direction by enacting a state-level QSBS benefit. Legislation signed into law in 2025 allows certain QSBS gains to receive favorable treatment beginning January 1, 2025. The legislation reflects the state’s broader economic development strategy centered on attracting high-growth startups through tax policy rather than increasing taxes on startup investors and stakeholders. As states increasingly compete for innovation-driven growth, New Jersey may offer a preview of how some states may seek to distinguish themselves from states moving toward decoupling.
States can use QSBS to compete for startup activity
QSBS may increasingly become a platform for interstate competition for startups; some states may view innovation incentives as worth preserving to encourage company formation and attract capital. Others, especially those facing budget pressure, may increasingly see QSBS as an untapped source of revenue. For the startup founders, state treatment of QSBS could become part of the calculation when deciding to build a company in one state or another.
As evidenced by the debates happening in state legislatures and the pushback to the federal QSBS expansion, this tax treatment is often incorrectly perceived as merely a benefit for wealthy investors. But startup founders and early employees rely on the tax treatment to de-risk the inherently risky move of launching or joining a new, innovative company — often at the expense of a higher-paying job at an established company. If anything, the policy should be modernized so it works better for startup employees, not just those with capital. Most startup employees receive stock options rather than direct stock grants, yet QSBS generally only applies once options are exercised, which means the holding period clock starts later and employees cannot take advantage of the exemption as easily. During their tenure, employees can also lose eligibility if the company exceeds QSBS size limits before the time they exercise their options. Policymakers could improve the benefits of QSBS by starting the holding period at vesting or grant, and by applying company-size tests at the time equity is granted. Reforms like these would help expand QSBS to be a more effective tool for startup workers and may help signal to states that this is not intended as just a tax break for investors but rather the broader startup ecosystem.
Policymakers should be careful in taking tax incentives for granted
QSBS was created to reward those who take on the risk and reward of building and investing in startup innovations. The recent state-level efforts to curb the impact of the QSBS exemption serve as a reminder that the impact of startup tax incentives can easily be taken for granted.
The United Kingdom offers a useful example. The Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) were specifically designed to encourage investment into early-stage companies through targeted tax relief. Both programs are widely credited with helping expand startup investment and strengthening London’s position as a global startup hub. Following the expansion of SEIS investment limits in 2023, fundraising under the program increased by more than 50 percent year-over-year. Startup tax incentives do matter, and policies supporting those incentives can meaningfully influence where capital flows and where startup ecosystems grow.
The same principle applies in the United States. As Congress has strengthened and expanded QSBS through OBBBA, states now face a choice about whether to align themselves with policies that encourage startup formation and long-term investment, or move in the opposite direction. States worried about their budgets should carefully consider the downstream effects that decoupling may have on their appeal to new businesses in innovation. In the long term, the initial savings may not ultimately be worth it.