By Aaron Pinegar

With some advance planning, certain business owners (other than corporations) can achieve substantial tax savings on cash sale proceeds by structuring the transaction as a sale of “qualified small business stock” (commonly referred to as “QSBS,” for short, or as “1202 stock” because it is governed by section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”).

Tax savings from the sale of QSBS

Section 1202 of the Code allows a percentage of the gain from a sale of QSBS (the “Gain Exclusion Percentage”) that has been held for specified minimum holding periods to be excluded from gross income.

The Gain Exclusion Percentage can be as high as 100% and depends on when the stock was acquired (or, in certain cases involving specified transfers, treated as acquired) and how long it has been held.

For a given tax year, the QSBS exclusion is generally capped at the greater of (1) a specified dollar amount (the “Fixed Dollar Cap”) (which is reduced by the amount of the taxpayer’s prior excluded QSBS gains with respect to such corporation) and (2) ten times the shareholder’s aggregate adjusted basis in the QSBS sold in such year (the “10X Cap”).

These limitations are applied on a per-shareholder, per-corporation basis.

The following table summarizes the interplay between the shareholder’s acquisition date, the Fixed Dollar Cap, Gain Exclusion Percentage, and minimum holding period required to apply such Gain Exclusion Percentage.

QSBS requirements

There are several requirements that must be satisfied for the QSBS gain exclusion to apply.

At a high level, these include:

1. The company issuing the stock must be classified as a domestic C corporation for tax purposes (and not be a C corporation that is subject to certain special tax rules, such as domestic international sales corporations, real estate investment trusts, real estate mortgage investment conduits, regulated investment companies, and cooperatives).
2. The stock must be received upon original issuance after August 10, 1993, and in exchange for cash, services (other than underwriter services), or property (other than stock). Limited exceptions to this original issuance requirement can apply in the case of stock acquired through testamentary transfers, gifts, partnership distributions, and certain types of restructuring/reorganization transactions.
3. During substantially all of the selling shareholder’s holding period, at least 80% (by value) of the corporation’s assets must be used in one or more qualified businesses.
4. The shareholder must have held the stock for the minimum required holding period.
5. At all times during the period from August 10, 1993, until immediately after the issuance of the stock, the “aggregate gross assets” of the corporation cannot have exceeded, (i) in the case of stock issued prior to July 5, 2025, $50 million or (ii) in the case of stock issued after July 4, 2025, $75 million (subject to inflation adjustments).
6. The corporation does not make certain disqualifying purchases of its own stock.

Tax planning to maximize the gain exclusion cap

The excluded gain limitation is illustrated by the following example.

Example 1. Suppose a founder (Founder) forms a business as a C corporation in 2020 and her stock qualifies as QSBS.

The business experiences significant growth, and in 2030 Founder sells 100% of her stock (which has zero basis) for $495 million.

As a sale of QSBS that Founder has held for more than five years, Founder can exclude 100% of her gain, subject to the cap described above.

In this case, Founder has zero basis, so the Fixed Dollar Cap applies – i.e., the first $10 million of Founder’s $495 million of gain is subject to zero federal income tax.

The remaining $485 million of gain exceeds Founder’s applicable excluded gain limitation and is subject to federal income tax as a long-term capital gain.

While Founder has successfully applied the QSBS rules to save taxes, even greater tax savings may be possible in certain circumstances.

Specifically, the QSBS rules provide that when property is contributed to a C corporation in a tax-deferred exchange for stock, the contributing shareholder’s stock basis (for QSBS purposes only) is equal to the fair market value of the contributed property on the date of the contribution.

Consider how this basis rule can increase the QSBS tax benefits, as illustrated in the following example.

Example 2. Assume Founder forms her business in 2020 as an LLC and does not elect to have her LLC classified as a corporation for tax purposes (meaning that the LLC would initially be classified as a disregarded entity).

Founder carefully tracks the value of the business over time, and when the value gets to $45 million in 2023, she converts her LLC to a C corporation in a fully tax-deferred manner.

Assume that Founder has zero basis at the time of conversion and that the resulting C corporation stock is QSBS.

Applying the basis rule above, Founder has a basis of $45 million in her C corporation stock for QSBS purposes (even though her actual tax basis is zero).

When Founder sells 100% of her stock in 2030 for $495 million, her first $45 million of gain is now ineligible for a QSBS exclusion.

However, she gets to apply the 10X Cap to exclude her next $450 million of gain (10 times her $45 million basis for QSBS purposes).

By waiting to convert her business to a C corporation, Founder has significantly increased her tax savings under the QSBS rules.

Risks with this planning strategy

While this tax strategy can deliver powerful results, it is not without risks and potential additional complexity.

For example, to achieve QSBS tax benefits, the selling shareholder must have held the stock for a specified minimum holding period.

By delaying the conversion to a C corporation, business owners delay the start of their QSBS holding period and thereby risk not having a sufficient holding period in the stock when an attractive offer comes from a buyer.

Depending on when the business was initially formed, this strategy may also result in the shareholders holding QSBS with varying QSBS attributes (e.g., different Gain Exclusion Percentages).

Consequently, the shareholders may need to not only document the value of the business at the time it is incorporated but also to document and track separate QSBS attributes for the stock.

Furthermore, the amount of built-in gain in the stock at the time of the conversion to a C corporation is not eligible for QSBS benefits.

As a result, if the value of the stock does not increase (or worse yet, declines) after the conversion to a C corporation, this strategy can reduce the QSBS benefit for the shareholder (as compared to what would have been the case if the business were originally formed in a C corporation).

Even if the value of the stock does increase after the conversion to a C corporation, there are circumstances under which the business owner would be better off converting to a C corporation at a lower valuation.

For example, if the ultimate exit in Example 2 was for $100 million, Founder would have been better off converting to a C corporation when the business value is $10 million (resulting in a QSBS exclusion of $90 million) than when it is $45 million (resulting in a QSBS exclusion of $55 million).

Thus, business owners employing this strategy are forced to decide when to convert to a C corporation before they have all the relevant information to maximize their tax savings.

There is also a valuation risk.

If the conversion occurs at a time when the value of the business assets is greater than the applicable limitation to qualify as a “qualified small business” (i.e., $50 million for stock issued prior to July 5, 2025, and $75 million (subject to inflation adjustments) for stock issued after July 4, 2025), then none of the stock issued to the shareholders in the conversion will be QSBS.

Keeping in mind that the IRS can always challenge valuations, it is prudent to leave some valuation “buffer” in determining when to convert to a C corporation.

Significantly, for a business in growth mode (and not making distributions to shareholders), operating in a pass-through structure at the outset may also subject the business to higher overall tax rates (and thereby slow growth) prior to the conversion to a C corporation.

Finally, it is also important to make sure the conversion of the business from a pass-through structure to a C corporation is accomplished in a tax-deferred manner.

The form used to convert the business to a C corporation can also impact the QSBS attributes of the resulting stock.

Sophisticated tax advisors can help navigate these complex issues.

To discuss potential QSBS tax benefits for your business, please contact Aaron Pinegar.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for informational purposes only and does not constitute legal advice. For more information, please contact a member of the Qualified Small Business Stock (QSBS) Tax Planning practice.

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