QSBS Planning for S Corps Under Section 1202

July 23, 2025  |  By

One of the earliest strategic decisions founders make is selecting a corporate structure. Many elect for S corporation tax status early on due to favorable pass-through treatment. However, as companies grow and seek venture funding or plan towards a lucrative exit, founders frequently convert to a C corporation—primarily to leverage the benefits of Qualified Small Business Stock (QSBS). While the sale of QSBS can significantly reduce taxes on a sale or exit, converting from an S corporation to a C corporation may jeopardize eligibility for the exclusion under Section 1202.

QSBS Eligibility and Conversion Issues

Under Section 1202, eligible stock must be obtained directly from the corporation in exchange for money, services, or property other than stock. This requirement can pose a challenge for existing entities converting into C corporations. In a typical S-to-C conversion, for example, founders receive new C corporation stock in exchange for their original S corporation stock, which violates this rule and generally disqualifies the new shares from QSBS treatment. Simply converting to a C corporation isn’t enough to qualify; eligibility depends on how the new stock is issued.

By comparison, LLCs taxed as partnerships or disregarded entities have more flexibility. They often convert through statutory conversions, mergers, or contribution-and-exchanges, which avoid stock-for-stock exchanges by transferring assets or partnership interests to the new corporation. As a result, the new stock is more likely to qualify under Section 1202.

Challenges for S Corps

For startups with minimal revenue, limited intellectual property, and few contracts, dissolving the existing S corporation and forming a new C corporation is often the most practical approach. Although dissolution triggers a taxable liquidation, the tax implications are generally minor when the company has negligible built-in gains.

For more developed companies, preserving QSBS eligibility takes more careful planning. Dissolving an existing entity can create significant upfront tax consequences, particularly if the company holds valuable assets. Many contracts also restrict transfers without third-party consent, making the transition more complex. Because of these risks, established businesses often need to consider alternative ways to convert without putting QSBS treatment at risk.

Alternative Methods for Mature Startups

Founders of more mature startups have two primary restructuring methods that can provide QSBS eligibility while maintaining the shares held at the S corporation level:

  1. Asset-for-Stock Exchange: The existing S corporation transfers all assets and liabilities into a newly created C corporation (“NewCo“), receiving NewCo stock in return. This method aims to preserve Section 1202 treatment by transferring property instead of a stock-for-stock exchange. Operationally, essential contracts, licenses, employee benefit plans, and EINs often need to be reassigned or renegotiated, which may cause potential operational disruption and increased administrative workload. Additionally, reassignment often requires third-party consents and can lead to delays, increased costs, or loss of favorable terms.
  2. Type F Reorganization + Section 351 exchange: This alternative strategy involves several sequential steps while preserving business continuity. Initially, founders create a new holding corporation taxed as an S corporation (“HoldCo”) that acquires complete ownership of the existing company (also an S corporation) (“OpCo”). HoldCo then makes a QSub election for OpCo, treating it as a disregarded entity for tax purposes and avoiding a taxable liquidation. HoldCo then contributes 100% of the ownership of OpCo to a newly formed C corporation (“NewCo”) in exchange for QSBS-eligible stock.

Though more involved than an asset-for-stock exchange, the Type F reorganization allows the company to maintain its existing operational structure. Since OpCo remains the active operating company, the business avoids having to reassign key assets like contracts, licenses, EIN, employee benefit plans, and registrations. This minimizes legal and administrative disruption, avoids delays tied to third-party approvals, and helps preserve relationships with customers, vendors, and regulators.

Retaining the original EIN also simplifies payroll tax accounts, state registrations, and regulatory licenses. Many government filings and commercial agreements are tied to the EIN, so changing it can trigger notice requirements or require new approvals. Avoiding those complications reduces both compliance burdens and legal risk.

However, this approach introduces a more complex three-entity structure that increases internal demands and requires more careful oversight. Each legal entity must maintain its own records, state filings, and compliance obligations. They may also need separate tax returns, financial statements, and bank accounts—all of which can make operations more complicated and drive up legal and accounting costs. For early-stage companies operating with lean teams or limited resources, these ongoing demands may outweigh the benefits unless there’s a clear path to funding or a near-term exit.

Conclusion

Choosing between an asset-for-stock exchange and a Type F reorganization with a Section 351 contribution requires careful consideration of operational needs, legal complexity, and long-term tax strategy. Both approaches preserve QSBS eligibility and avoid immediate tax liabilities. However, the optimal structure depends on the company’s specific circumstances, including contractual obligations, investor preferences, and the founding team’s ability to manage increased administrative responsibilities.

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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