Incorporator The Journal of U.S. Formation
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Editorial 7 MIN READ

Planning for QSBS: what you actually have to do at formation

Section 1202's 100% gain exclusion is the single largest tax break in the small-company code, and almost every disqualification is set on day one

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 7 sections
  1. The six gates you have to pass
  2. How the cap actually works
  3. Section 1045 as an escape valve
  4. State conformity is the trap almost nobody checks
  5. Stacking § 1244 on the downside
  6. What to do at formation
  7. Sources

ection 1202 lets a founder exclude up to $10 million of federal gain on qualified small business stock, or ten times basis, whichever is larger. The requirements to qualify are almost entirely set at formation, and almost all of them are easy to blow.

This is the short version of how to plan for QSBS eligibility in 2023, written for a founder who is about to file a charter and would rather not spend the next five years realizing the entity was the wrong one.

The six gates you have to pass

Six conditions have to be satisfied under IRC § 1202 for stock to qualify. Miss any one of them and the exclusion is gone.

First, the issuer has to be a domestic C corporation. Not an LLC, not an S corporation, not a partnership. Section 1202(c)(1) requires the issuer to be a C corporation "during substantially all" of the taxpayer's holding period. A Delaware C corp that converts to an S corp midway through is out for the post-conversion period. If you file as an LLC now and convert to a C corp later, the QSBS clock does not start on your founding date; it starts on the date the stock was issued by the C corporation, and the pre-conversion appreciation is outside the exclusion. This is the single most common unforced error.

Second, the stock has to be issued directly by the corporation to the taxpayer. Secondary purchases do not qualify. Cash, services, or other property count as valid consideration under § 1202(c)(1)(B), but a contribution of appreciated property resets basis to fair market value at contribution for QSBS purposes (§ 1202(i)(1)), which can cost you the 10x multiplier if you are not careful.

Third, the corporation's aggregate gross assets have to be $50 million or less at all times from August 10, 1993 through immediately after issuance. That is the § 1202(d) gross-assets test. Aggregate gross assets means cash plus the adjusted basis of other property, with contributed property valued at fair market value at contribution. Once a corporation crosses $50 million, every share issued after that moment is permanently disqualified, even if the company later shrinks below the threshold. Future rounds do not retroactively kill previously issued QSBS, but they do cap it.

Fourth, at least 80% of the corporation's assets by value have to be used in the active conduct of a "qualified trade or business" during substantially all of the holding period (§ 1202(e)(1)). Section 1202(e)(3) defines that by exclusion. Disqualified fields include health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any business whose principal asset is the reputation or skill of employees, banking, insurance, financing, leasing, investing, farming, extraction, and the operation of a hotel, motel, or restaurant. The SSTB overlap with § 199A is close but not identical. A SaaS platform serving law firms qualifies; a law firm with a SaaS product does not.

Fifth, the taxpayer has to hold the stock for more than five years before sale. The clock runs from the issuance date. A secondary purchaser gets a fresh clock but no tacking, which is again why founders who sell shares to co-founders mid-stream often destroy eligibility without realizing it.

Sixth, the acquisition-date window determines the exclusion percentage: 50% for stock acquired August 11, 1993 through February 17, 2009; 75% from February 18, 2009 through September 27, 2010; and 100% for anything acquired on or after September 28, 2010. The 100% tier is also exempt from AMT preference and from the 3.8% net investment income tax under § 1411(c)(4). The pre-2010 windows still carry a 7% AMT preference item and are therefore meaningfully worse.

How the cap actually works

The exclusion is capped at the greater of $10 million or 10 times the taxpayer's aggregate adjusted basis in QSBS of the issuing corporation, per issuer, per taxpayer. The $10 million is a lifetime cap; the 10x cap is measured year by year on stock sold that year. A founder who contributed appreciated property worth $2 million at formation gets up to $20 million excluded from that issuer. A founder whose only contribution was $100 in cash still gets the $10 million floor.

Because the cap is per taxpayer, gifting QSBS to non-grantor trusts multiplies it. Stock gifted retains its QSBS character and holding period in the donee's hands under § 1202(h)(1). A founder with a large expected exit can set up multiple non-grantor trusts early, each becoming its own $10 million bucket. The planning has to happen before the exit discussion becomes concrete for the valuation to hold up.

Section 1045 as an escape valve

If a founder sells QSBS before the five-year mark, § 1045 allows the gain to be rolled into new QSBS within 60 days, with the old holding period tacked onto the new. The replacement stock has to itself qualify as QSBS at acquisition, the election has to be made on a timely filed return, and the sold stock has to have been held at least six months. It is the only mechanism for preserving the clock across a pre-five-year liquidity event.

State conformity is the trap almost nobody checks

California repealed its QSBS conformity in 2013. R&TC § 18152 previously allowed a 50% exclusion for California-qualifying stock; after Cutler v. Franchise Tax Board, the Legislature struck the provision rather than fix the in-state-active-business test the court had held unconstitutional. As of 2023, a California resident selling QSBS gets the federal exclusion and pays full California tax on the gain, up to the 13.3% top rate. On a $10 million federally excluded sale, that is roughly $1.3 million of California tax a Nevada or Texas resident would not owe.

Pennsylvania, Alabama, and New Jersey also do not conform. Most other states with personal income taxes either conform automatically to federal AGI (inheriting the exclusion) or conform with modifications that still pass most of the break through. The practical planning move for a founder in a non-conforming state is to establish residency elsewhere well before the liquidity event, with all the standard domicile-change friction that implies. Moving the week before a sale does not work.

Stacking § 1244 on the downside

Section 1202 is the upside play. Section 1244 is the downside hedge, and the two stack cleanly. Section 1244 allows the first $50,000 (single) or $100,000 (joint) of loss on stock of a "small business corporation" to be treated as an ordinary loss, deductible against ordinary income rather than trapped at $3,000 a year of capital-loss offset. The corporation has to have received $1 million or less in capital for its stock at issuance, the stock has to have been issued for money or property (not services), and the taxpayer has to be the original holder. These conditions overlap heavily with the QSBS rules, so stock structured to qualify for § 1202 almost always qualifies for § 1244 as well. On the upside, up to $10 million excluded from federal tax; on the downside, the first $100,000 of loss offsetting ordinary income.

What to do at formation

File as a C corporation if an exit is even plausibly in scope. The conventional advice to default to an LLC for flexibility is fine for a lifestyle business and wrong for anything institutional. If you have already formed as an LLC and are inside the first year, a conversion can be done cleanly; every month of delay leaks QSBS basis into the pre-conversion period. See our companion piece on the C-corp vs S-corp § 1202 question for the mechanics of that decision.

Issue founder shares immediately and for real consideration, even if it is nominal. Keep the corporation under $50 million of gross assets until all founder and option-pool issuances are complete. Document the qualified-trade-or-business classification in the board minutes at the time of issuance, so there is a contemporaneous record if the SSTB question ever arises on audit. And keep every stock certificate, every cap-table entry, and every board consent indefinitely. The five years in the holding period is the floor, not the ceiling; the IRS can question QSBS classification years later, and the burden is on the taxpayer.

Rule of thumb: if you would be embarrassed to learn, five years from now, that a choice you made this week cost your cap table ten million dollars, form the C corp and issue the stock today.

Sources

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