Section 1202 of the Internal Revenue Code provides that noncorporate taxpayers may exclude certain gains on the disposition of Qualified Small Business Stock (QSBS) held longer than the minimum required holding period. One element of this exclusion is that the stock held by the taxpayer must have been acquired at its original issuance in exchange for cash, property (other than stock) or services.1 This raises questions as to the impact of transferring QSBS, even in tax-free transfers, because the transferee did not acquire the stock in an original issuance. Several narrow categories of exception to this general rule are provided by statute. (For information about QSBS in light of the recent passage of H.R. 1, the One Big Beautiful Bill Act, see Holland & Knight's previous alert, "One Big Beautiful Bill Act Increases Tax Benefits for Qualified Small Business Stock," July 10, 2025.)
Stock Conversions
If QSBS held by a taxpayer is converted into stock of the same corporation, such newly acquired stock is treated as QSBS.2 This presumably is true even if the issuer is not a qualifying small business at the time of the conversion (e.g., it has more than $75 million of gross assets).3 Accordingly, an exchange of one class of stock, which is QSBS in the hands of the taxpayer, for a different class of stock in the same corporation will result in the newly issued class of stock also being QSBS. The newly issued stock will have a tacked holding period and be treated as though it was acquired on the issue date of the exchanged stock (i.e., the old stock) for purposes of determining how long the stock was held and which exclusion percentage should apply.4
Tax-Free and Other Transfers
A transferee of QSBS will be treated as having 1) acquired the stock in the same manner as the transferor (i.e., at an original issuance) and 2) held such stock during any continuous period immediately preceding the transfer during which the transferor held the stock if such transfer is:
- by gift
- at death, or
- from a partnership to a partner (i.e., a distribution by a partnership to a partner)5
Transfers from a partnership to a partner are limited to include only those with respect to which "requirements" similar to those of Section 1202(g) are met at the time of the transfer (other than the holding period).6 Section 1202(g)(2) is titled "requirements" and provides that an amount meets the requirements of paragraph (g)(2) if the stock is QSBS in the hands of the partnership and the partner was a partner in the partnership at the time the QSBS was acquired by the partnership. Though no authorities have been published to clarify exactly what is meant by "requirements similar to those" of Section 1202(g), presumably it is those enumerated requirements in Section 1202(g)(2) that apply. Accordingly, stock transferred by a partnership to a partner will retain its QSBS status only if the partner was a partner in the partnership at the time the QSBS was acquired.
Though not listed explicitly as a "requirement" in subsection 1202(g), the restriction imposed in Section 1202(g)(3) likely also applies. This rule would limit the amount of the transferred stock that will continue to be treated as QSBS in the hands of the partner to such partner's indirect interest in the QSBS on the date it was acquired by the partnership.
For example, assume a partnership acquired 100 shares of QSBS and 100 shares of non-QSBS stock. Partner A and Partner B each own 50 percent of the partnership at the time of the stock acquisitions. At some future time, the partnership liquidates, transferring all of the QSBS to Partner A and the non-QSBS stock to Partner B. Only half of the stock transferred to Partner A would be treated as QSBS in the hands of Partner A post-liquidation. The remaining half would simply lose its status as QSBS, and no one would receive the benefit of the Section 1202 exclusion.
As a second example, assume Partner A, Partner B and Partner C each contributes $100 to partnership ABC, which immediately thereafter acquires QSBS for $200. After the acquisition, the partnership redeems out Partner C for $100 in cash, leaving Partner A and Partner B as 50/50 partners going forward. Subsequently, the partnership liquidates, distributing half of the QSBS to each of Partner A and Partner B. Because each partner had a one-third interest in the partnership at the time the stock was acquired, each of Partner A and Partner B will hold stock, two-thirds of which is treated as QSBS and one-third of which is not (i.e., at the time of acquisition, each partner had an indirect interest in the QSBS of $66.67 and an indirect interest in the partnership's cash of $33.33, such that when Partner A and Partner B receive $100 of stock, $66.67 of that stock, or two-thirds, would retain its status as QSBS).
Note that there is no exception from the original issuance rule that covers contributions to a partnership. And without an explicit exception, a partnership that receives stock as a contribution that is otherwise QSBS in the hands of the contributing partner will thereafter hold stock that it did not receive in an original issuance from the company; it merely received the stock secondhand from the contributing partner, who received it at original issuance. Accordingly, the stock will lose its status as QSBS upon a contribution to a partnership, and the exclusion will be forever lost.
Stock Dividends and F Reorganizations
Section 1202(h)(3) provides that rules similar to Section 1244(d)(2) shall apply for purposes of Section 1202. Like Section 1202, which provides beneficial tax treatment for gains on QSBS, Section 1244 provides beneficial tax treatment with respect to losses on QSBS. The regulations underlying Section 1244(d)(2) interpret it to apply to stock dividends, E reorganizations and F reorganizations.7 Given that Section 1202(f) already covers conversions of one share of stock for another share issued by the same corporation (i.e., an E reorganization), this rule likely covers only stock dividends and F reorganizations, as applied similarly to Section 1202.
The rule for F reorganizations is straightforward. Stock in a successor corporation in an F reorganization will be treated as QSBS to the extent it was so treated with respect to the predecessor corporation.8 The applicable regulations, however, reference only common stock. Accordingly, it is somewhat unclear whether preferred stock exchanged in an F reorganization also would qualify.
Nontaxable stock dividends, similarly, should adopt the status of the stock giving rise to the dividend. If the stock giving rise to the stock dividend is QSBS, then the stock received as a nontaxable dividend also should be QSBS.9 To the extent only some of the stock giving rise to the dividend is QSBS, a pro rata amount of the distributed stock should be treated as QSBS.10 Note the regulation is limited to stock dividends of common stock.
For example, assume the taxpayer holds 100 shares of common QSBS. If the taxpayer receives a nontaxable stock dividend of five additional common shares, those additional shares also should be QSBS. If, however, the taxpayer holds 100 shares of common QSBS and another 100 shares that are not QSBS (e.g., they were purchased from another shareholder instead of by original issuance from the company), then only half of the shares distributed in the stock dividend would be treated as QSBS.
Section 351 Transactions and Reorganizations
Section 1202(h)(4) provides, generally, that stock of another corporation (successor stock) exchanged for QSBS (exchanged stock) in a Section 351 transaction or a reorganization described in Section 368 also will be QSBS, treated as though the successor stock was acquired on the date the exchanged stock was originally acquired. Absent this provision, the exchanged stock would not be QSBS because stock exchanged for other stock, even in an original issuance, is not itself QSBS (i.e., to be QSBS, stock must be received in exchange for services, cash or property other than stock).
This taxpayer-favorable rule is subject to a few limitations. The first limitation toggles on whether the issuer of the successor stock is a qualified small business (i.e., its gross assets, inclusive of the target company, are less than the applicable limitation and the company satisfies the other requirements under Section 1202(d)).11 If the successor corporation is itself a qualified small business at the time of the exchange, then all of the successor stock received in the exchange will be treated as QSBS, including with respect to future appreciation.12 If, however, the successor corporation is not a qualified small business at the time of the exchange, the built-in gain inherent in the exchanged stock will continue to enjoy the benefits of the exclusion in Section 1202 upon the subsequent sale of the successor stock, but any appreciation in the successor stock after the exchange date will not be excludable.13
For example, assume taxpayer owns QSBS that represents 100 percent of the stock of a corporation. When the stock has a built-in gain of $1 million, the taxpayer causes its corporation to merge into another corporation in an A reorganization, with the other corporation surviving. The consideration is solely stock in the successor corporation. Five years later, the taxpayer sells the successor stock for a gain of $10 million.
If the successor corporation is a qualifying small business at the time of the merger, the entirety of the gain on the sale of the successor stock will be excludable up to the applicable percentage (i.e., 50 percent, 75 percent or 100 percent). If, however, the successor corporation is not a qualifying small business at the time of the merger, only $1 million of the gain will be excludable up to the applicable percentage. The remaining $9 million gain will be taxable as capital gain.
The second limitation is specific only to a Section 351 transaction. In such a transaction, the successor corporation must control the exchanged corporation immediately after the transaction within the meaning of Section 368(c) (i.e., it must own 80 percent of the exchanged corporation).14 If this control requirement is not satisfied, the successor stock will not be treated as QSBS.
To illustrate this limitation, assume each of Founder A and Founder B owns 50 percent of a corporation, the stock of which is QSBS in their hands. Founder A later contributes his 50 percent interest to another corporation in a transaction qualifying under Section 351. Because the other corporation does not own at least 80 percent of the stock of the exchanged corporation, the successor stock held by Founder A will not be QSBS, and Founder A will not be entitled to a Section 1202 exclusion upon the later disposition of the successor stock. If, however, both Founder A and Founder B contribute all of their QSBS to the successor corporation, all of the stock received in the exchange will be QSBS in their hands, subject to the above limitation relating to whether the successor corporation is itself a qualified small business.
For more information or questions, please contact the authors.
Notes
1 IRC § 1202(c)(1)(B).
2 IRC § 1202(f)(1).
3 The gross asset threshold for periods prior to the effective date of the One Big Beautiful Bill Act was $50 million.
4 IRC § 1202(f)(2).
5 IRC § 1202(h)(1)-(2).
6 IRC § 1202(h)(2)(C).
7 Treas. Reg. § 1.1244(d)-3(a).
8 Treas. Reg. § 1.1244(d)-3(d)(1).
9 Treas. Reg. § 1.1244(d)-3(b)(1).
10 Treas. Reg. § 1.1244(d)-3(b)(2) and (3)(Ex. 2).
11 In testing the aggregate gross asset value of the issuing company in a Section 351 or Section 368 transaction, the rules can be interpreted to require the inclusion of gross asset value of both the acquiring entity and the target entity. See Section 1202(d)(1)(B). What is less certain is whether the target entity is valued at its aggregate adjusted tax bases amount or at the fair market value of its assets. See Section 1202(d)(2)(A) and (d)(2)(B).
12 IRC § 1202(h)(4)(B).
13 Id.
14 IRC § 1202(h)(4)(D).
