Employees can be compensated with QSBS and elect the Section 1202 capital gains tax exclusion. There are various scenarios where this can happen. One is a startup company that is tight on cash, but because the company is high-growth and disrupting its target market the stock has a huge upside. The company can make up for the low salaries by compensating its employees with a comfortable stock options package. Although employees still have to pay income tax on the stock they may still be able to maximize their return when it is sold after it is held for five years. Since the stock is required to be held for five years to elect the Section 1202 capital gains exclusion it can incentivize employees to stick around and help build the company, while hopefully increasing the value of their shares and taking advantage of the tax exclusion.
Another quick example could be a company that has been operating for years with the same owners. The owners might want to sell the company to the employees through an Employee Stock Option Plan transaction and restructure the company from an LLC to a C Corporation. This is a good way for long-term owners to pay back their employees and incentive them to stay on as well as have more to offer when recruiting future employees. If the company qualifies as a Section 1202 qualified small business the newly issued stock to the employees would qualify for the Section 1202 capital gains tax exclusion if it is sold within a minimum of five years, further incentivizing the employee to stay.