Capital Gains

Capital gains are the profit realized when a capital asset is sold for more than its cost basis. They are taxed at preferential long-term rates when held over one year and at ordinary income rates when held one year or less. Capital assets include startup equity, stock options after exercise, and shares received in an exit. For startup founders and early employees, capital gains tax is the dominant tax category at exit, and the difference between short-term and long-term treatment can be 20 percentage points or more on every dollar of proceeds.

The federal long-term capital gains (LTCG) rate schedule for 2025: 0 percent on gains below the lower threshold (roughly $47K single, $94K married filing jointly); 15 percent on gains in the middle band (up to roughly $519K single, $584K MFJ); 20 percent on gains above those thresholds. Add the Net Investment Income Tax (NIIT) of 3.8% for filers above $200K single or $250K MFJ MAGI, so high-income founders face an effective federal LTCG rate of 23.8%. Short-term capital gains (STCG) apply when the asset is held one year or less; STCG is taxed as ordinary income, with federal marginal rates up to 37% plus NIIT, for an effective top rate of 40.8%. State capital gains tax stacks on top: California taxes capital gains as ordinary income (top rate 13.3%, so combined ~37% effective at the top), New York similarly (top combined ~33.8%), while Florida, Texas, Washington, and several other no-income-tax states tax capital gains at 0% state level. The QSBS exclusion (Internal Revenue Code Section 1202) lets founders, early employees, and early investors exclude federal capital gains tax on stock acquired at original issuance from a US C-corp. The One Big Beautiful Bill Act (signed July 4, 2025) created a two-regime structure. For QSBS issued on or before July 4, 2025: up to $10 million or 10x cost basis (whichever is greater) excluded after a 5-year holding period, with the company having to be under $50M in gross assets at issuance. For QSBS issued after July 4, 2025: the per-issuer cap rises to $15 million (inflation-adjusted after 2026), the gross-assets ceiling rises to $75 million, and a tiered holding period applies: 50% exclusion at 3 years, 75% at 4 years, 100% at 5 years. The maximum potential exclusion under the new regime can reach $750 million. A founder selling $10M of QSBS-qualified stock at exit pays $0 federal capital gains tax versus $2.38M without QSBS, a difference that has shaped how thousands of founders structure their entity and equity timing. Section 1045 rollover lets a founder defer capital gains by reinvesting QSBS proceeds into new QSBS-qualifying stock within 60 days, useful when an exit happens before the five-year QSBS holding period is met.

Ryan's Take

Capital gains tax is where most founders discover that the headline exit number is not the spendable number. The math founders care about: federal LTCG plus NIIT plus state. In California, that is roughly 37% on every dollar above the QSBS exclusion. In Texas, it is 23.8%. The 13-point difference is real money: on a $20M exit above the QSBS cap, that is $2.6M in disposable income. This is part of why founders relocate before exits, why holding periods matter even when the cash offer is on the table, and why early QSBS election is worth more than most founders realize until they are sitting at the closing call doing the math in their head. Get a tax advisor before you sign anything binding. Not at the close. Before.

What founders get wrong: Treating capital gains as a flat number. There are at least four moving parts: the holding period (short vs. long), the federal LTCG bracket (0/15/20 plus 3.8% NIIT), state taxation (0 to 13.3% depending on state), and QSBS eligibility (which can eliminate federal tax entirely on up to $10M or 10x basis pre-OBBBA, $15M post-OBBBA, with the new tiered holding periods). Founders who think "I will pay 20% on the exit" routinely miss 10-15 points either way. Model the actual cash before signing.

FAQ

What is the difference between short-term and long-term capital gains?
Short-term capital gains apply to assets held one year or less and are taxed as ordinary income (federal top rate 37% plus NIIT). Long-term capital gains apply to assets held over one year and are taxed at preferential federal rates of 0, 15, or 20 percent plus NIIT. The difference at the top bracket is roughly 17 percentage points.

What is the federal capital gains tax rate?
Long-term capital gains rates are 0, 15, or 20 percent federal depending on income, plus 3.8 percent Net Investment Income Tax for higher earners. Top combined federal rate is 23.8 percent. Short-term gains are taxed as ordinary income, with a top combined federal rate of 40.8 percent.

How does QSBS reduce capital gains tax?
QSBS under IRC Section 1202 lets founders and early holders exclude federal capital gains on stock acquired at original issuance from a US C-corp. For stock issued on or before July 4, 2025: $10M or 10x cost basis (whichever is greater) after 5-year hold, company under $50M gross assets at issuance. For stock issued after July 4, 2025 (OBBBA): $15M cap, $75M gross-assets ceiling, tiered exclusion (50% at 3 years, 75% at 4 years, 100% at 5 years), inflation-adjusted after 2026.

Does state capital gains tax stack on top of federal?
Yes. State capital gains tax is independent of federal and varies widely. California taxes capital gains as ordinary income (top rate 13.3 percent). New York similarly (top combined effective ~33.8 percent federal plus state). Florida, Texas, Washington, and other no-income-tax states levy zero state capital gains tax.

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