The type of gain you recognize depends on how you acquired the shares. If you hold shares from exercising incentive stock options (ISOs) in a qualifying disposition, you generally recognize capital gain. If you hold shares from NSOs (non-qualified stock options), you recognized ordinary income at exercise, and any subsequent gain is capital gain. Restricted stock produces capital gain measured from your basis at the time of vesting (or 83(b) election, if made).
In my experience, the first question to answer before doing any tax modeling is: what kind of equity do I actually hold, and how did I come to hold it? The answer drives everything else. Founders who received restricted stock at company formation typically recognize capital gain measured from their basis — which, if they made a timely 83(b) election, is the fair market value at the date of the election (usually very low at the company's earliest stages). Employees who exercised incentive stock options (ISOs) and held the resulting shares have more complex tax profiles: ISOs receive favorable tax treatment, but a sale of ISO shares is either a qualifying disposition (held more than two years from grant date and one year from exercise date) — which generates capital gain — or a disqualifying disposition (held for shorter periods) — which generates ordinary income on the spread at exercise and capital gain or loss only on the difference between the exercise price and the sale price. Employees who hold shares from non-qualified stock options (NSOs) recognized ordinary income at the time of exercise (the spread between exercise price and 409A FMV), paid taxes then, and now face capital gain treatment only on the appreciation above the FMV at exercise. Understanding which category your shares fall into is the foundation of any tax analysis, and I always recommend founders consult a tax advisor before agreeing to a sale price.
For capital gains, the holding period determines whether you pay long-term capital gains rates (for shares held more than one year) or short-term capital gains rates treated as ordinary income (for shares held one year or less). At the federal level, the difference is currently up to approximately 20 percentage points — long-term rates top out at 20% (plus 3.8% NIIT) versus ordinary income rates up to 37%.
The holding period rule is one of the most straightforward aspects of the tax analysis, but the starting point for the holding period depends on your equity type. For restricted stock, the holding period generally starts when the shares vest — or, if you made an 83(b) election, from the date the shares were granted and the election was filed. For ISOs, the holding period for qualifying disposition purposes starts from the date of exercise, not the date of grant. For NSOs, the holding period for capital gain purposes starts from the date of exercise, and the basis is the FMV at exercise. The practical implication for secondary sales is this: if you exercised options recently and are considering an immediate secondary sale, you may be selling at short-term capital gains rates, which are significantly higher than long-term rates. I typically advise clients to model both scenarios — the after-tax proceeds from selling now at short-term rates versus waiting to clear the one-year mark for long-term treatment — before deciding. The difference is material. On $1 million of gain, the difference between 37% ordinary income rates and 23.8% long-term rates is approximately $132,000 in federal tax. For a founder with larger gains, the holding period decision can be worth hundreds of thousands of dollars.
Selling before the five-year mark required for Section 1202 QSBS treatment forfeits the exclusion entirely. There is no partial credit for partial holding periods. For founders holding shares that qualify for the 100% federal capital gains exclusion under QSBS, the cost of selling early can be millions of dollars in avoidable federal tax.
Section 1202 of the Internal Revenue Code provides a federal capital gains exclusion of up to 100% for gains from the sale of Qualified Small Business Stock held for more than five years. The exclusion is capped at the greater of $10 million or 10 times the taxpayer's adjusted basis in the stock — for founders who received equity at or near company formation with minimal basis, the $10 million cap is typically the binding constraint. The requirements to qualify include: (1) the stock must be common stock issued by a domestic C corporation; (2) it must have been acquired at original issuance (not on secondary markets); (3) the corporation must have had gross assets of $50 million or less at the time of issuance; and (4) the corporation must be engaged in an active qualified trade or business (most technology and software companies qualify; certain service businesses do not). If all requirements are met, the five-year holding period is the final gate. Selling one day before the five-year anniversary forfeits the entire exclusion — there is no prorated benefit. For a founder holding $10 million in qualifying QSBS gain, early sale costs approximately $2.38 million in federal tax that would have been excluded under Section 1202. For founders with gains above the $10 million cap, the analysis is similar but the ceiling is higher. I have sat across the table from founders who made the decision to sell early without realizing what they were giving up — the QSBS conversation should happen before any sale discussions begin, not after.
California does not conform to the federal QSBS exclusion under Section 1202. California residents pay state income tax on the full capital gain from a QSBS-eligible sale, at California's top marginal rate of 13.3%, regardless of how long the stock was held. This makes California the most tax-costly state for QSBS holders and is a major factor in the decision calculus for founders with significant appreciated equity.
The California QSBS non-conformity issue is one that I make sure every California-based founder understands before they make any decision about selling pre-IPO shares. Federal law provides a 100% capital gains exclusion on qualifying QSBS after a five-year holding period. California, however, has never adopted Section 1202, and California's Franchise Tax Board taxes capital gains from QSBS sales in full, at ordinary income rates up to 13.3% for California's highest earners. This means that a California founder who holds QSBS and sells after five years — achieving a complete federal exclusion — still owes California income tax on the full gain. On a $10 million gain, that is $1.33 million in California state tax owed even in the best-case federal scenario. The inverse is also true: California taxes short-term and long-term capital gains at the same rates, so there is no California tax benefit to holding for the one-year federal long-term holding period — only federal tax savings. For founders who are able to establish residency in a QSBS-favorable state (such as Texas or Florida, which have no state income tax) before selling, the full federal Section 1202 exclusion is achievable. Whether this approach is feasible, and whether it withstands state tax scrutiny as a genuine change of residency, requires careful analysis and planning — another area where a qualified tax advisor is essential.
Exercising ISOs without selling the shares in the same year generates alternative minimum tax (AMT) liability — the spread between the exercise price and the FMV at exercise is an AMT preference item. If the ISO shares are subsequently sold in the same year as exercise (a disqualifying disposition), the AMT preference item disappears. If sold in a different year, the AMT paid on exercise generates an AMT credit that can offset regular tax in future years.
The AMT rules for ISOs are one of the most technically complex and frequently misunderstood areas of startup equity taxation. Here is the core framework. When you exercise an ISO and hold the resulting shares (rather than immediately selling them), the spread — the difference between the FMV at exercise and the exercise price — is an AMT preference item. It is added to your AMT taxable income and may generate an AMT liability. The 2024 and 2025 AMT exemption amounts are $137,000 for single filers and $220,800 for married filing jointly (subject to phaseout). For founders and employees exercising ISOs with a large spread in a high-value company, the AMT liability can be substantial. If you then sell the ISO shares in a secondary transaction in the same tax year as exercise, the transaction is a disqualifying disposition (assuming you haven't held for the qualifying disposition period). A disqualifying disposition eliminates the AMT preference item — you recognize ordinary income on the spread at exercise, which is included in regular taxable income, and your AMT base is reduced accordingly. This can actually improve your tax situation compared to holding. If you sell in a different tax year from exercise, the AMT you paid on exercise generates an AMT credit — the minimum tax credit (MTC) — which can offset regular tax in the years following the ISO exercise. The MTC is usable in years when your regular tax liability exceeds your AMT liability, but it can take years to fully utilize depending on your tax situation. I always advise founders who have exercised ISOs to discuss the AMT implications with a tax advisor before agreeing to a secondary sale date.
Before agreeing to sell pre-IPO shares, run a full tax model that covers: capital gains type (short-term vs. long-term), QSBS eligibility and five-year holding status, ISO AMT implications if applicable, California or other state tax, and your basis (including whether an 83(b) election was made). Engage a tax advisor with startup equity experience before you commit to a price or a closing date.
In my experience, the founders and employees who achieve the best tax outcomes in secondary transactions are the ones who do the planning before agreeing to sell — not after. The key questions to work through, ideally with a tax advisor who has experience in startup equity, are: First, what is my holding period, and does it matter (is it already over one year, or am I close to a threshold)? Second, does my equity qualify for QSBS, and if so, have I held for five years? Third, if I hold ISOs, did I exercise them this year? If so, what are the AMT implications of selling this year versus next? Fourth, what is my basis, and was an 83(b) election made? Fifth, what state am I a resident of, and does that state recognize the federal QSBS exclusion? Sixth, what is the total federal and state tax on the proposed sale, and does it change the economic picture materially? A secondary sale that looks attractive at $50 per share may look significantly less attractive after a comprehensive tax analysis. Getting that analysis before you negotiate — and certainly before you sign a purchase agreement — allows you to negotiate a price that reflects your actual after-tax economics. By the time you sign, the deal is largely set.
In my experience, the biggest tax mistake founders make in secondary transactions is treating tax as an afterthought. The legal mechanics of the transaction are what I help navigate — but the tax picture needs a qualified CPA or tax attorney who specializes in startup equity. Get that conversation scheduled before you start exploring secondary platforms or buyer introductions.
Gurpreet S. Bal is a Partner at Foley and Lardner LLP in Silicon Valley, where he advises startups, founders, and investors on SAFE financings, venture capital rounds, mergers and acquisitions, acquihires, and IPOs. He has represented clients in hundreds of transactions with aggregate deal value exceeding $60 billion across AI, semiconductors, fintech, and emerging technology. Prior to his career as a corporate lawyer and transaction advisor, he served with the U.S. Department of Justice and as an international and cross-border tax advisor at a Big 4 accounting firm.