The One Big Beautiful Bill Act (OBBB) has spurred even more interest among businesses that may qualify for the tax benefits associated with qualified small business stock (QSBS), including businesses that currently are classified as S corporations for federal income tax purposes. The benefits of Section 1202 of the Internal Revenue Code (Code),1 which contains the rules for QSBS, have expanded based on recent amendments made by the OBBB. Shareholders of S corporations thus have new incentives to consider converting to a C corporation structure to the extent Code Section 1202 might apply.
Direct Conversion to C Corporation
The simplest method for an S corporation to become eligible to issue QSBS is to convert to C corporation status by filing a statement of S status revocation with the IRS (Direct Conversion). The S corporation shareholders will not benefit from QSBS with respect to their historic S corporation stock because QSBS must be originally issued by a C corporation. Any subsequent issuances, however, could be QSBS if the company otherwise qualifies at the time such stock is issued. This limitation on the applicability of Code Section 1202 applies only to future issuances, – not to currently existing stock – making this option largely unappealing and leaving opportunities on the table unnecessarily. Accordingly, Direct Conversion is not generally advisable.
S Corporation Merger into C Corporation
Similar to the Direct Conversion, a merger of an S corporation into a new C corporation will not produce the desired result. As with Direct Conversion, any stock received by the S corporation shareholders in a merger also will not be QSBS. But, any newly issued shares acquired post-merger may be QSBS if such an issuance satisfies the applicable standards.
In Leto v. United States,2 a federal district court in Arizona denied QSBS treatment on C corporation shares received by a S corporation shareholder as part of a merger. Code Section 1202(c)(1)(B) provides that in order for stock to be QSBS, it must be acquired at its original issue in exchange for services, money or other property, but not including stock. Because the S corporation shareholder received the C corporation stock in exchange for its S corporation stock, the exchange did not qualify for QSBS treatment.
The court in Leto did not expound on how, exactly, a merger constituted an impermissible stock-for-stock exchange, but this conclusion is correct. In an all-stock statutory merger, the acquired corporation is treated as transferring all of its assets and liabilities to the acquiring corporation in exchange for the acquiring corporation's stock. The acquired corporation is then deemed to have liquidated, distributing the newly acquired stock of the acquiring corporation to the old shareholders of the acquired corporation. In this last step, it becomes clear that the old shareholders are receiving the stock of the acquiring corporation in exchange for their stock in the acquired corporation as part of the deemed liquidation. Accordingly, such a structure simply doesn't work to achieve the desired result.
There are exceptions where a stock-for-stock exchange does qualify under Code Section 1202(h), but those exceptions apply only when the stock given up in the exchange is already QSBS. In the case of a merger of an S corporation into a C corporation, the stock being given up is not QSBS by definition. So, those exceptions to the general prohibition on stock-for-stock exchanges will not apply.
Form a New C corporation to Be a Subsidiary of the Existing S Corporation
Though an S corporation cannot itself issue QSBS, Code Section 1202(g)(4)(B) explicitly contemplates that an S corporation may own QSBS issued by another qualifying corporation. Qualifying gain on the disposition of QSBS by an S corporation flowing through to the S corporation shareholders will be excludable under Code Section 1202, subject to certain limitations that require the S corporation shareholder to have held its interest in the S corporation on the date the S corporation acquired the underlying QSBS.3 Accordingly, an S corporation can acquire stock in a subsidiary corporation, which may be treated as QSBS if all other requirements are satisfied.
If the S corporation shareholders desire for their existing stock to benefit from QSBS, the S corporation can transfer legal title to its assets to a newly formed C corporation (NewCo) (an Asset-Dropdown). The S corporation will thus become the parent of NewCo and hold the QSBS issued by NewCo, assuming NewCo is a qualifying small business and the issuance of its stock was in exchange for money or property (not including stock). Note that any existing built-in gain inherent in the assets contributed to NewCo will not be excludable; only future appreciation will be excludable under Code Section 1202. (For a discussion of pre-contribution gains and rules pertaining to holding periods that may impact the ultimate exclusion percentage, see Holland & Knight's previous alert, "Conversion of Partnership and LLC Interests into Qualified Small Business Stock," Aug. 4, 2025.)
This Asset-Dropdown restructuring should be tax-free pursuant to Code Section 351. However, taxpayers undertaking such a transaction should carefully analyze the impact of Code Section 269, which could operate to disallow the exclusion under Code Section 1202.
Code Section 269 provides that if a person acquires control of a corporation, the IRS may disallow any "allowance" that results if the principal purpose for such acquisition is the evasion or avoidance of tax.4 An allowance refers to anything in the internal revenue laws that has the effect of diminishing tax liability, including an exclusion from taxation.5 The Asset-Dropdown, standing alone, clearly confers control over NewCo to the S corporation. Accordingly, if the principal purpose of the transaction is the avoidance or evasion of tax, then the IRS conceivably could deny the Code Section 1202 exclusion. The notion of evasion or avoidance in this context is broad and not limited to cases involving criminal penalties, civil penalties or fraud.6
Courts and certain IRS guidance have concluded that even where a taxpayer forms or acquires a corporation with an eye toward obtaining a tax benefit, Code Section 269 will not apply to prevent "tak[ing] advantage of provisions that represent a deliberate granting of tax benefits."7 Though the exclusion under Code Section 1202 is a deliberate granting of a tax benefit by U.S. Congress, there is no authority directly on point to confirm that this is the type of tax benefit that should be ignored for purposes of determining the application of Code Section 269. This issue should be scrutinized by any taxpayer engaging in an Asset-Dropdown transaction (or the alternative F reorganization structure).
The F Reorganization
A variation of the Asset-Dropdown restructuring is a tax-free reorganization complying with Code Section 368(a)(1)(F) (F Reorganization). In an F Reorganization, the shareholders contribute all of their stock in the historic S corporation to a newly formed S corporation (Holding Company). An election is filed on IRS Form 8869 to treat the historic S corporation as a qualified subchapter S subsidiary (QSUB) of Holding Company, which effectively causes the historic S corporation to be disregarded and its assets and liabilities to be treated as held directly by Holding Company.8 At least one day after the IRS Form 8869 is filed, the historic S corporation (now a QSUB) converts under state law into a single-member limited liability company (LLC), disregarded for federal income tax purposes.9 These steps should be regarded as an F Reorganization.
After the F Reorganization is complete, Holding Company contributes all of the equity of the LLC to a newly formed subsidiary C corporation. As with the Asset-Dropdown alternative, this alternative results in an S corporation parent owning all of the QSBS of its C corporation subsidiary with the variation that the historic business is owned by the C corporation subsidiary through a disregarded single-member LLC instead of directly by the new C corporation. The F Reorganization has at least two potential advantages over the Asset-Dropdown approach: 1) It does not require transfer of legal title to the assets of the historic business and so may avoid the need to obtain third-party consents, and 2) the historic business arguably can retain its employer identification number (EIN).10
The F Reorganization alternative may also be subject to attack by the IRS under the liquidation-reincorporation doctrine, which can be used by the IRS to ignore a liquidation of one corporation when it is followed by a contribution of the same assets to a new corporation. The risk can be explained as follows: If the S corporation shareholders simply contributed the stock of the historic S corporation to a new S corporation but did not file the QSUB election, they would be treated as contributing stock to a new S corporation in exchange for the stock of the old S corporation. The old S corporation would immediately revert to a C corporation (again, absent the filing of a QSUB election). From the perspective of Holding Company, it merely accepted stock previously owned by the historic shareholders in a Code Section 351 transaction and not in an original issuance of stock by the subsidiary to Holding Company. Accordingly, such subsidiary C corporation stock would not be QSBS.
This result is avoided by filing the QSUB election. Because the transaction is an F Reorganization, there is no deemed contribution of stock or assets. Holding Company steps into the shoes of the historic S corporation as if it had been in that structural position the entire time. However, if Holding Company then immediately contributes the LLC (the historic S corporation, now converted to a disregarded entity) to a new C corporation, the structure is immediately back in the same position as if the QSUB election had never been filed. The IRS could argue that the QSUB election and subsequent contribution of assets to a new C corporation should be stepped together under the step transaction doctrine and liquidation-reincorporation doctrine to ignore the F Reorganization and instead treat the transaction as a simple contribution of stock to a new S corporation. This outcome may be remote, given the long history of both the IRS and courts respecting the separate existence of an F Reorganization, even if done as part of a larger transaction. But, it is nonetheless worthy of consideration.
Because of the step-transaction risk, it may be advisable to instead use the Asset-Dropdown structure. Alternatively, the historic S corporation may create a new C corporation subsidiary and transfer its assets and liabilities to that new subsidiary using a divisive merger statute, where available, which should be treated identically to the Asset-Dropdown structure for federal income tax purposes.11 The benefit of the divisive merger structure is that, like the F Reorganization, no actual assignments of assets are needed, as the movement of assets and liabilities occurs by operation of law like any other merger under state law. But, there is no step transaction or liquidation-reincorporation risk.
For questions or more information about converting from an S corporation to QSBS, please contact the authors. For more on Section 1202 QSBS developments, visit Holland & Knight's comprehensive resource page.
Notes
1 All references to the "Code" are to the Internal Revenue Code of 1986, as amended, except as otherwise indicated.
2 Leto v. United States, No. CV-20-02180-PHX-DWL (D. Ariz. 2022).
3 IRC § 1202(g)(1) and (2).
4 IRC § 269(a).
5 Treas. Reg. § 1.269-1(a).
6 Treas. Reg. § 1.269-1(b).
7 CCA 202501008, Jan. 3, 2025, quoting Rocco, Inc. v. Commissioner, 72 T.C. 140, 152 (1979) (holding that Section 269 did not apply to disallow deferral of tax resulting from adoption of the cash method of accounting, in part because the tax benefits of the cash method were "consciously granted" by Congress).
8 Line 14 on IRS Form 8869 should be checked "yes" to indicate to the IRS that the transaction is an F Reorganization.
9 In some cases, the historic S corporation is already an LLC under state law and, therefore, cannot convert. In such cases, a check-the-box election may be filed under Treas. Reg. § 301.7701-3 to elect disregarded status, assuming the S election (or a prior-filed election to be treated as a C corporation) has been in place for at least five years. If the historic S corporation has not been treated as a corporate entity for federal income tax purposes for at least five years, the historic S corporation may be merged into a new LLC subsidiary of Holding Company to cleanse it of any corporate character.
10 In the authors' experience, the IRS has been inconsistent in its response to allowing a converted entity to retain its prior EIN. Consult a qualified tax advisor if retaining your EIN is an important issue for your business.
11 A "divisive merger" is one where two or more entities are created from one legal entity, which is the corporate law equivalent of cellular mitosis. Only a few states have divisive merger statutes, including Texas and Delaware, although the Delaware divisive merger statute may be used only with LLCs. Even if the historic S corporation is not organized in a jurisdiction with a divisive merger statute, presumably the entity could be redomesticated to such a state, and a divisive merger could thereafter be used to reorganize the assets of the company.
