By Aaron Pinegar

With some advance planning, certain business owners (other than corporations) can achieve substantial tax savings on the sale of their business 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.

QSBS planning for S corporations

As noted above, in order for stock to qualify as QSBS it must be received on original issuance from a domestic C corporation – i.e., stock issued by an S corporation is not QSBS.

Is there a way for business owners that have formed their business as an S corporation to achieve QSBS tax benefits?

One possibility would be for the S corporation to convert to a C corporation, though this would only allow stock issued after the conversion to qualify as QSBS.

However, the rules of section 1202 expressly contemplate that (subject to certain limitations) the shareholders of an S corporation may obtain QSBS benefits with respect to stock issued by a C corporation to the S corporation.

This raises the possibility of having the S corporation transfer the relevant business to a newly formed subsidiary C corporation in exchange for the stock of that C corporation.

A number of different structures could be used to accomplish such a transfer.

Each of these alternative structures may raise numerous non-tax considerations that should be taken into account before deciding on which structure should be chosen.

In addition, the alternative structures may raise the possibility that the IRS could raise various legal arguments to challenge the QSBS status of the resulting C corporation stock.

These risks should be carefully analyzed by sophisticated tax advisors before proceeding.

But assuming the C corporation stock is respected as QSBS, this type of restructuring would not only allow the S corporation shareholders to achieve QSBS tax benefits but may also increase those benefits by causing the 10X Cap rather than the Fixed Dollar Cap to apply.

In this regard, 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 the following example.

Suppose a founder (Founder) forms a business as an S corporation (S Corp) in 2020.

In 2023, when the value of the business is $45 million, S Corp transfers the business (in a fully tax-deferred manner) to a newly formed subsidiary C corporation (C Corp) in exchange for the stock of C Corp.

Assume that S Corp has zero basis at the time of transfer and that the stock of C Corp is QSBS.

Applying the basis rule above, S Corp has a basis of $45 million in C Corp stock for QSBS purposes (even though the real basis is zero).

S Corp then sells 100% of the C Corp stock in 2030 for $495 million.

This is a sale of QSBS that S Corp has held for more than five years, with the following tax consequences to Founder (as an S corporation shareholder).

The first $45 million of gain is ineligible for a QSBS exclusion.

However, since S Corp has $45 million of basis for QSBS purposes, the 10X Cap applies to exclude the next $450 million of gain.

Complexities and risks with this restructuring

While starting a business as an S corporation and later transferring the business to a subsidiary C corporation may deliver powerful results under the QSBS rules, it is not without risks and potential additional complexity.

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

Consequently, the S corporation may need to not only document the value of the business at the time it is transferred to a C corporation, 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 the business is transferred to a C corporation (the first $45 million of gain in the example above) is not eligible for QSBS benefits.

As a result, if the value of the stock does not increase (or worse yet, declines) after the transfer to a subsidiary C corporation, this approach can reduce the QSBS benefit (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 business is transferred to a C corporation, there are circumstances under which the business owner would be better off transferring the business to a C corporation earlier at a lower valuation.

For example, if Founder’s ultimate exit in the example above is for $100 million, Founder would be better off transferring the business 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 (which would result in a QSBS exclusion of $55 million).

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

There is also a valuation risk.

If the transfer of the business 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 S corporation 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 transfer the business to a subsidiary 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 transfer of the business to a subsidiary C corporation.

Moreover, certain transfers of the shares of the S corporation following the transfer of business to a subsidiary C corporation may cause available QSBS benefits to be subject to additional limitations.

Taxpayers who form their business as an S corporation and later restructure in the manner described above to get QSBS benefits also extend the exit timeline for achieving those benefits, because the required minimum holding period for achieving QSBS benefits does not start until the stock is issued by the subsidiary C corporation to the S corporation.

Finally, it is also important to make sure the transfer of the business to a subsidiary C corporation is accomplished in a tax-deferred manner.

Sophisticated tax advisors can help you 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.