Advanced Section 1202 (QSBS) Planning for S…

*This article was updated on March 20, 2025.

Section 1202 provides for a substantial exclusion of gain from federal income taxes when stockholders sell qualified small business stock (QSBS).[1] But a number of requirements must be met before a stockholder is eligible to claim Section 1202’s gain exclusion. Those requirements have been addressed in a series of articles on Frost Brown Todd’s website. This article focuses on the planning challenges facing S corporation owners interested in pursuing the benefits of Section 1202’s gain exclusion. Additional information can be found on our QSBS & Tax Planning Services page.

The following points illustrate why S corporations and QSBS don’t play together well:

Only C corporations can issue QSBS. Stock issued by an S corporation can never qualify as QSBS, even if an S corporation converts to C corporation status. See Section 1202(d)(1).
Stock doesn’t qualify as QSBS unless the issuing corporation has the status of a domestic (US) C corporation during “substantially all” of a stockholder’s QSBS holding period. Conversion of a C corporation to S corporation status generally result in the termination of the QSBS status of outstanding stock unless the S corporation period is short and has been terminated before the stock is sold). See Section 1202(c)(2)(A).
In order to be eligible to claim section 1202’s gain exclusion, the corporation issuing the QSBS must generally be a C corporation when the QSBS is sold. See Section 1202(c)(1).

S corporations are pass-through entities for federal income tax purposes as owners share the income and loss of the business which pass through on Schedule K-1s to the stockholders. There is nothing wrong with operating a business through an S corporation, and many owners benefit from a pass-through entity tax regime, but business owners seeking Section 1202’s gain exclusion must operate their business through a C corporation. Stock issued while a business operates through an S corporation can never qualify as QSBS, although QSBS can be issued once the business is converted to C corporation status. If a C corporation with outstanding QSBS makes an S corporation election, the corporation will no longer qualify as qualified small business under Section 1202, and the outstanding stock will no longer qualify as QSBS (see the discussion below regarding the possible conversation back to C corporation status as a fix for the problem).

Owners of S corporations have two options if they decide to seek the benefits of QSBS and the C corporation’s 21% tax rate. The corporation’s S election can simply be terminated and the corporation will revert to C corporation status. Or the S corporation can be restructured using a Type F reorganization that results in the formation of a new S corporation holding company and ultimately converts the operating S corporation business into a single-member LLC subsidiary of a newly organized C corporation (“Newco”). Both of those options are discussed below.

Options available for S corporation business owners who want to benefit from Section 1202’s gain exclusion.

As noted above, stock issued while a business operates as an S corporation can never qualify as QSBS. Owners can simply cause the S corporation’s election to be terminated if they aren’t concerned about the status of outstanding stock, and issue additional stock qualifying as QSBS. A possible strategy associated with termination of the S corporation election would be to recapitalize the corporation with preferred and common stock, with liquidation preference of the preferred approximating the corporation’s fair market value, and issue additional “cheap” common stock for money, contribution of property or performance of services, each of which is permissible under Section 1202.[2] Based on the valuation methodologies used in connection with 409A valuations (typically based on valuing the common stock after subtracting the liquidation preference of the preferred), the value of the newly-issued common stock should be low, which allows for the issuance of the “cheap” common stock. But an obvious issue with this strategy is that the historic S corporation stockholders will not be holding QSBS and may not be interested in diluting participation in future corporate growth through the issuance to other stockholders of a substantial block of “cheap” common stock.

In most cases, existing S corporation stockholders will instead prefer to position themselves to partially qualify for Section 1202’s gain exclusion with respect to their existing S corporation stock. S corporation stockholders seeking to benefit from Section 1202 should consider whether they would qualify for engaging in the Type F reorganization restructuring described below (the “Restructuring”). A Restructuring that includes a Type F reorganization governed by Section 368(a)(1)(F) involves first organizing a new corporation (Holdco) and contributing the existing S corporation stock to Holdco, followed by making a QSub election on Form 8869 (with the Type F reorganization box checked), followed by the conversion of the subsidiary QSub to a disregarded LLC, and finally followed by the contribution of the single-member LLC interest to a newly-organized C corporation (Newco) in exchange for QSBS.[3] The contribution of the single-member LLC interest (which is treated as a property contribution) and issuance of QSBS is intended to qualify as a Section 351 nonrecognition exchange. The hope and expectation of the business owners is that the stock issued by Newco will meet Section 1202’s eligibility requirements to qualify as QSBS. Undertaking the initial Type F reorganization has the benefit of permitting the operating business to retain its historic EIN and avoids undertaking the equivalent of an asset sale transaction in terms of assigning assets and contracts to Newco, and often triggering various consent requirements. Newco is often organized in Delaware, given investors and advisors familiarity with Delaware corporations. When the Restructuring is completed, the business is operated at the lower rung of a three tier structure, assuming no investors are brought in as part of global Section 351 transaction to owner stock of the newco-C corporation: (1) the newly-organized S corporation holding company is the upper tier, (2) Newco (the C corporation issuing QSBS) is the middle tier, and (3) a single-member LLC (the historic operating business) owned by the Newco is the bottom tier.

Potential tax benefits of undertaking the Restructuring.

The Restructuring described above provides several potential tax benefits.

The operating business will be operated through a C corporation on a going-forward basis, which benefit from the favorable 21% federal income tax rate.

Section 1202 contemplates that Holdco, as an S corporation “pass-thru entity” (see Section 1202(g)(4)), can own and sell the QSBS of Newco. When Holdco sells its QSBS, the stockholders who held shares of Holdco on initial issuance date of the QSBS (where a Restructuring is involved, in connection with the Section 351 nonrecognition exchange of property for stock) are potentially eligible claim Section 1202’s gain exclusion. When property (assets or LLC interest) is contributed by Holdco to Newco, the basis of Holdco in the QSBS for Section 1202 purposes issued in exchange is no less than the fair market value of the contributed property contributed (see Section 1202(i)(2)(B)). Holdco’s (and indirectly its stockholders’) holding period for Newco QSBS commences when the QSBS is issued in the Restructuring. Newco often issues additional QSBS to investors and service providers either as part of or sometime after the Section 351 nonrecognition exchange (subject to taking into account Section 351’s “control immediately after the exchange” requirements).

The special “Section 1202 tax basis” established by Section 1202(i)(2)(B) is significant for two reasons. Because the tax basis of contributed property is equal to fair market value (FMV) for purposes of Section 1202, the contributor won’t be entitled to claim the gain exclusion for any gain attributable to the pre-contribution period. For example, if contributed property has a regular tax basis of zero and a Section 1202 tax basis (i.e., FVM) of $10 million, the later sale of the QSBS for $80 million would trigger $10 million of capital gain and a potential $70 million gain exclusion under Section 1202. Second, the typical per-taxpayer (in this case, each S corporation stockholder) gain exclusion cap is $10 million for gain arising out of the sale of Newco’s QSBS. But Section 1202(b)(1)(B) provides an alternative gain exclusion cap (commonly referred to as the “10X Cap”) which is “10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.” In the example above, assuming there are two 50% stockholders, each stockholder would be responsible for $5 million of capital gain and would qualify for up to $50 million in gain exclusion under Section 1202 (the 10X cap would allow for a potential per-stockholder potential gain exclusion of 10X x $5 million = $50 million). An important aspect of dealing with the Section 1202(i)(2)(B) basis issue is substantiating the FMV of the contributed property for purposes of Section 1202(i)(2)(B), which typically means obtaining an independent appraisal.[4]

Potential tax issues to consider as part of the planning process.

As noted above, the sharing of Section 1202’s gain exclusion among S corporation stockholders is based on ownership of Holdco stock as of the date of the Restructuring. A transferee of S corporation stock after the date of QSBS issuance won’t share in Section 1202’s gain exclusion. The holder of S corporation stock issued after the date of QSBS issuance won’t share in Section 1202’s gain exclusion. Section 1045 Treasury Regulations contemplate that a transferee of a gifted partnership interest can share in Section 1202’s gain exclusion, but there is no comparable provision for gifting of S corporation stock. Obviously, any gifting or other transfers or issuances of S corporation stock should occur before the Restructuring. Post-Restructuring gifts would need to be undertaken using QSBS issued by the C corporation.

An S corporation holding the stock of a C corporation can sometimes result in troublesome tax issues. For example, a problem could arise if there is a desire to distribute earnings out of Newco to the S corporation. If the S corporation has earnings and profits (generally arising prior to the S corporation election), distributions would be treated as passive income, which could trigger the termination of the S corporation election under Section 1362(d)(3) and the imposition of a 25% tax on the excess net passive income under Section 1375. Planning should focus on structuring non-passive payments. On the flip side, retaining excess earnings in Newco can trigger both excess working capital problems under Section 1202 and potential exposure to the accumulated earning tax.

The importance of substantiating a bona-fide business purpose for undertaking the Restructuring.

As mentioned above, business owners who elect to convert into a C corporation have two ways to accomplish that goal. They can simply terminate the S corporation election and issue additional QSBS for money, property or services, or they can undertake the Restructuring described above, with Newco issuing QSBS for in exchange for their contributed operating business. Before either alternative is selected, an important first step is for business owners to substantiate that decisions made by the Board of Directors and equity owners were made for bona-fide business reasons (i.e., not for tax avoidance). The IRS has a history of asserting “pervasive judicial doctrines” to attack taxpayers whose transactions satisfy the required statutory “form” but are not what Congress intended in the eyes of the IRS. One of these doctrines provides the basis for the IRS arguing that taxpayers must have a bona-fide business purpose for undertaking a transaction beyond tax benefits. While there are tax authorities supporting the conclusion that if there are two ways to achieve an end result, the taxpayer is not obligated to select the path that results in higher taxes, certainly from a practical standpoint it makes sense to have a response if asked why the Restructuring was selected instead of terminating the S corporation election. It is important to keep in mind that taxpayers have the burden of proof if the IRS challenges a return position. In situations where the IRS asserts a tax avoidance purpose for a transaction, a taxpayer must not only have undertaken a transaction for bona-fide business reasons but also must be prepared to produce credible substantiation that those business reasons were the driving force behind the decision of the Board of Directors and owners to select the chosen form of conversion transaction (here the Restructuring).

Not surprisingly for those who have been involved with corporate restructuring and M&A transactions, there are a number of business reasons why the Restructuring might be selected over terminating the S corporation election. For example, family business owners often engage in wealth and estate planning at the S corporation level using trusts and gifts of S corporation stock as vehicles to accomplish various non-tax goals. When it comes time to concert to a C corporation, there is often a genuine desire to leave the S corporation intact rather than terminate the S election and bring in additional investors and employees as stockholders. In some cases, there are business and investment assets owned through the S corporation that are not contributed into Newco, which tips the scale in favor of the Restructuring as distributing those assets out of the S corporation before converting to C corporation status would trigger a deemed taxable sale. Selecting the Restructuring results in a parent-subsidiary arrangement, which can be favored both from an asset protection and financing standpoint. The Restructuring’s three-tier entity structure brings with it flexibility to issue incentive equity at both the Newco and operating LLC level. The Restructuring transaction facilitates re-domesticating the operating business to Delaware. Investors are generally more comfortable investing in a newly-organized Delaware corporation than a re-purposed former S corporation. The preceding non-tax business purposes are just a sampling of some of the reasons why the Restructuring may be the favored choice for business reasons. As noted above, if the choice is to undertake the Restructuring, it is important not only to have bona-fide business reasons for undertaking the Restructuring, but also the be prepared to substantiate those reasons with contemporaneous documentation confirming the process the Board of Directors and business owners went through while considering the conversion options.

What options are available for a business that issued C corporation stock but later elected S corporation status?

In some cases, stock was issued by a C corporation that later made an S corporation election.[5] Under those circumstances, simply terminating the S corporation election might be a viable option, if the stockholders would later satisfy Section 1202’s requirement that the QSBS was issued by a corporation that was a C corporation for “substantially all” of the stockholders’ QSBS holding period. Unfortunately, what constitutes “substantially all” has not been defined by tax authorities for purposes of Section 1202. Other tax authorities have defined “substantially all” to mean as much as 95% or as little as 51% of the applicable measurement period. For planning purposes, “substantially all” should fall somewhere between 70% to 95% of a stockholder’s QSBS holding period. For example, Section 1202’s “substantially all” requirement might be satisfied if a business has the status of C corporation when stock is first issued and when it is sold, and the corporation operated as a C corporation during eight out of 10 years (80%) of a stockholder’s QSBS holding period.

A strategy that would most likely fail — liquidating the S corporation and contributing the assets to a newly-organized C corporation.

Although a liquidation – reincorporation strategy may seem appealing, there are several potential tax issues that should be carefully considered. The liquidation of an S corporation is generally treated as a deemed sale of the corporation’s assets at their fair market value. A deemed sale could result in substantial up-front tax liability, with no guarantee that Section 1202’s benefits would ultimately be available. If the S corporation holds inventory, receivables or assets that would trigger depreciation recapture, gain on the deemed sale would be taxed at ordinary income rates.[6] If the S corporation has built-in gains at the time of liquidation, the liquidation would also trigger a corporate level tax on the built-in gains.[7] Finally, the IRS might challenge a two-step liquidation – reincorporation plan by invoking step-transaction doctrine, the liquidation-reincorporation doctrine, or other similar judicial doctrines. Business owners should also consider whether there would be non-tax issues associated with a liquidation – reincorporation transaction.

Are there planning options for business owners interested in Section 1202’s benefits if their corporation issued stock as an S corporation and is now operating as an C corporation?

Good planning options are limited where the S corporation has already terminated the S election is now operating as a C corporation. A Restructuring type transaction won’t work because a C corporation cannot claim Section 1202’s gain exclusion. The C corporation can simply issue additional stock that qualifies as QSBS, and purchases of additional common or preferred stock by investors would work fine. But that leaves the original S corporation stockholders holding non-QSBS and employees being granted QSBS as incentive equity a potentially large tax bill since a Section 83(b) election would be necessary to commence the running of the QSBS holding period.

A possible approach that at least partially solves some of the issues identified above would be to recapitalize the corporation with preferred and common stock, causing the value of the common stock to be depressed by the liquidation preference of the outstanding preferred stock (similar to the recapitalization plan discussed above). The C corporation could then issue additional common stock for money, contribution of property or performance of services. The terms of the preferred stock must be carefully structured to avoid triggering ordinary income treatment when the stock is sold to a third party.[8]

Contact Scott Dolson if you want to discuss any Section 1202 or Section 1045 issues by video or telephone conference. You can also visit the QSBS & Tax Planning Services page to get our latest insights and analysis.

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[1] References to “Section” are to sections of the Internal Revenue Code of 1986, as amended. Many states, but not all, including notably California and New Jersey, do not follow the federal treatment of QSBS. There are a number of articles on the Frost Brown Todd website addressing the benefits of Section 1202’s gain exclusion and the various eligibility requirements and planning issues associated with seeking and obtaining Section 1202’s benefits. The website also includes several articles focused on the workings of Section 1045. See Frost Brown Todd’s QSBS library.

[2] If this approach is consideration, the parties would need to navigate through the possible application of Sections 305 and 306.

[3] See Revenue Ruling 2008-18, 2008-1 CB 674 and Revenue Ruling 64-250, 1964-2 CB 333. IRS tax authorities treat the new S corporation holding company is treated for tax purposes as a continuation of the historic S corporation. The LLC that is contributed into the newco-C corporation retains the historic EIN of the historic S corporation, while the new S corporation holding company obtains a new EIN (even though it is treated as a continuation of the historic S corporation).

[4] For purposes of substantiating charitable contributions, Section 170(f)(11)(ii) provides that the term “qualified appraiser” means an individual who (1) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations prescribed by the Secretary, and (2) regularly performs appraisals for which the individual receives compensation. Section 170 (f0(11)(E)(iii) provides that an individual will not be treated as a qualified appraiser with respect to any specific appraisal unless that individual demonstrates verifiable education and experience in valuing the type of property subject to the appraisal. It seems reasonable that appraisers with similar qualifications would carry the greatest weight in connection with QSBS related appraisals.

[5] Stock issued as of the date of an S corporation’s formation would not be considered as being issued by a C corporation in the situation where the Form 2553 S corporation election is made after the date of issuance of the stock but relates back to the date of the corporation’s formation. For federal income tax purposes, the stock issued on day one would be treated as having been issued by an S corporation.

[6] See Section 1239.

[7] See Section 1374.

[8] The potential application of Sections 305 and 306 should be considered.

Advanced Section 1202 (QSBS) Planning for S Corporations