Preserving QSBS: Initial Hurdles and Maintaining Eligibility

August 14, 2025  |  By

For startup founders, early employees, and investors, Qualified Small Business Stock (QSBS) can offer one of the most significant tax benefits in the Internal Revenue Code (IRC): the exclusion of up to $15 million (or 10x the adjusted basis) in capital gains upon exit. But accessing that exclusion isn’t automatic. QSBS is subject to detailed rules under Section 1202, with eligibility determined by factors such as the company’s formation, the manner in which equity is issued, and events occurring during the holding period. This article explores the common pitfalls that may jeopardize QSBS status and how to navigate the complexities of Section 1202.

Initial QSBS Qualification Hurdles

Satisfying the “Qualified Small Business” Requirement

To receive shares of QSBS, the startup must meet the broader “Qualified Small Business” criteria under the IRC, discussed in further detail here. In addition to satisfying all other requirements at the time of issuance, founders, investors, and early-employees should be aware of two crucial points:

  • $75M Asset Limit: The company must have aggregate gross assets of $75M or less at the time of stock issuance and immediately afterward. This includes funds raised, contributed property, and IP. Later-stage startups approaching that threshold should monitor asset levels as they consider whether new investors will purchase stock in a Qualified Small Business.
  • Timing of Stock Issuance: For instruments like convertible notes, stock options, or warrants, QSBS eligibility begins only when stock is actually issued.[1] If a company surpasses the $75M limitation before the conversion or exercise event, the resulting shares may not qualify. Additionally, purchasers of restricted stock granted for services can start the QSBS holding period at the grant date by filing a timely Section 83(b) election. Without this filing, the holding period does not begin until the stock vests. [2]

Original Issuance Requirement

To qualify for QSBS treatment, shares must be issued directly by the startup—typically in exchange for money, property, or services—rather than purchased from an existing stockholder.[3] As a result, secondary sales or transfers do not meet the “original issuance” test.

Common risks:

  • Secondary Transactions: Purchasing shares from a departing founder can help clean up the cap table, but those shares would not meet the “original-issuance” test—even if the company is otherwise considered a Qualified Small Business. 
  • Equity Compensation: Stock acquired through option exercise can qualify, but only if the underlying security is actual stock in a corporation. Phantom equity, restricted stock units, and profits interests (common in LLCs) don’t meet the QSBS definition of “stock.”

Entity Conversions and S corporations

For companies originally formed as LLCs, most conversion methods satisfy the requirements of Section 1202 and permit the issuance of QSBS to former-LLC owners. For example, when an LLC converts by statute, the LLC is deemed for tax purposes to contribute all of its assets and liabilities to the new corporation (NewCo) in exchange for NewCo stock. The LLC then liquidates, causing the distribution of the NewCo stock to the former LLC members.

One significant hurdle, however, occurs when an LLC elects to be taxed as an S corporation. Section 1202 requires that QSBS be issued in exchange for money or property, but not “stock.”[4] As a result, common conversion methods such as statutory conversions, mergers, or contribution and exchanges generally violate this restriction due to the contribution of S corporation stock to NewCo.

Risks During the Holding Period

Disqualifying Redemptions

When founders or employees seek liquidity, or when the company aims to clean up the cap table, the company can directly repurchase shares from stockholders—a transaction known as a “redemption” under the IRC. However, these transactions can create significant QSBS eligibility risks if not carefully managed. Section 1202 specifies restrictions on redemptions to prevent manipulation of QSBS status or abusive rollover planning. There are two key redemption scenarios that can jeopardize QSBS treatment:

  1. Redemptions From the Holder or Related Parties: If the company redeems stock from a QSBS holder, or from a related party (such as a spouse, minor children, or an entity the individual controls 50% or more of), and the redemption (i) exceeds a de minimis amount[5], and (ii) occurs within two years before or after the shares were issued, then the holder’s shares may be disqualified from QSBS treatment. 
  2. Significant Redemptions: Even if the redemption does not involve a QSBS holder or related party directly, large-scale redemptions exceeding 5% of the company’s stock (by value) within a one-year window before or after issuance can disqualify all stock issued during that period from QSBS eligibility.

Redemptions that fall into either category not only risk existing QSBS shares from disqualification, but may also prevent newly issued shares from initial eligibility. Failure to satisfy the safe harbors under Section 1202 can lead to a retroactive loss of QSBS status.[6]

Non-Qualifying Transfers

Founders often transfer shares for estate planning, charitable donations, or reallocating the company’s ownership. A gift to a family trust can inadvertently disqualify those shares from QSBS treatment, and this risk becomes more acute as founders plan their personal or family wealth. Section 1202 prohibits certain stock transfers, including[7]:

  • transfers to non-grantor trusts
  • contributions to partnerships or LLCs
  • transfers to corporations

Stock Rights and Recapitalizations

Recapitalizations can reorganize a company’s capital stack, often adding new classes of stock or changing preferences. While these events are generally benign from a QSBS perspective, certain transactions can impair QSBS eligibility:

  • New Classes of Preferred Stock: Creating new classes with substantially different rights or liquidation preferences may unintentionally affect QSBS eligibility. The IRS may scrutinize whether these changes materially alter the original economic arrangement, potentially disrupting QSBS continuity.
  • Significant Economic Adjustments: Recapitalizations involving material changes in economic rights, such as introducing participating preferred stock with high liquidation preferences or redemption features, may trigger IRS scrutiny. These adjustments could create substantially different equity instruments, risking QSBS treatment.

Practical Considerations for Founders & Investors

Beyond initial QSBS eligibility, founders should maintain best practices to ensure ongoing compliance, protecting investors’ potential gains and enhancing fundraising appeal.

Importance of Record-Keeping

  • Maintain organized cap tables and track gross asset values.
  • Track all equity issuances, conversions and transfers.
  • File timely Section 83(b) elections for restricted stock. Filing ensures the QSBS holding period starts upon grant rather than vesting, preserving eligibility.

NVCA Financing Documents and QSBS Considerations

The model NVCA financing documents provide two primary QSBS protections for investors that founders should remain aware of when negotiating a priced round:

  1. Charter Protective Provisions: Includes protective provisions that restrict the company’s ability to repurchase or redeem its stock (other than de minimis or customary employee buybacks), helping preserve QSBS eligibility for current and future investors.
  2. Investors’ Rights Agreement: Includes covenants prohibiting QSBS-harming actions without investor approval, and typically incorporates a QSBS questionnaire to easily monitor ongoing eligibility.

VC Funds, SPVs, and QSBS Pass-Through

Many investors acquire ownership through special purpose vehicles (SPVs) or venture capital funds. Under Section 1202’s pass-through rules, each beneficial owner or limited partner may be able to claim the QSBS exclusion at exit, provided they were part of the SPV or fund at the time the QSBS shares were purchased.[8]
 Consequently, investors who join after the fund’s investment into the portfolio company typically cannot claim QSBS for those earlier-purchased shares.

Conclusion

Effective QSBS planning requires attentiveness at every stage; mistakes in issuing shares or during the holding period can forfeit valuable tax exclusions. Engaging experienced advisors to review each financing, redemption, or restructuring can help preserve eligibility and optimize long-term capital gains.

Footnotes
[1] Y Combinator’s template Safes contain the following language: “the parties acknowledge and agree that for United States federal…income tax purposes this Safe is, and at all times has been, intended to be characterized as stock, and more particularly as common stock for purposes of [Section]…202 of the Internal Revenue Code.” However, despite the company and investor contracting to this tax treatment, it is not binding on the IRS’s determination. IRS guidance and tax court rulings typically defer to a debt versus equity analysis that has not yet been applied to Safes, let alone the treatment of Safes under Section 1202.
[2] 26 USC § 83(b); Treas. Reg. § 1.83-4(a)
[3] 26 USC § 1202(c)(1)
[4] 26 USC § 1202(c)(1)(B)
[5] 26 USC § 1202(e)(3)(C)
[6] Rev. Rul. 2007-49; Treas. Reg. §1.83-1(c)
[7] 26 USC § 1202(g)
[8] 26 USC § 1202(g)(1)-(4)
Posted in: Funding & Capital Raising, Tax

About the Author(s)

Bobby Gojuangco

Bobby Gojuangco is an attorney at Vela Wood. He focuses his practice in the areas of venture financing, M&A, and taxation.

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