Original Issuance, Redemptions, Transfers, and the Per-Issuer Cap

Qualified Small Business Stock Under IRC §§1202 and 1045 — Part III of IV

Part II addressed the tests a company must satisfy to issue qualified small business stock. A company can satisfy every one of them, and a particular holder’s shares can still fail. Two problems account for nearly all such failures: how the stock was acquired and what the company did with its own stock around the issuance date. This installment addresses both, plus the cap and the transfer rules.

I. Original Issuance

QSBS must be acquired by the taxpayer at original issuance, directly from the corporation or through an underwriter, in exchange for money, property other than stock, or as compensation for services. IRC §1202(c)(1)(B). Stock purchased from another shareholder does not qualify, however early the purchase and however small the company. This forecloses QSBS treatment for most secondary purchases, including tender offers and founder liquidity transactions.

For option holders, the clock and the qualification date run from the issuance of shares on exercise, not from grant. Under the post-OBBBA tiers, that makes early exercise worth a fresh look: exercising three years before an anticipated exit converts ordinary capital gain into a 50% exclusion, and four years into 75%.

II. Eligible Holders and the Conduit Rule

The exclusion is available to any taxpayer other than a C corporation, which in practice means individuals, trusts, and estates. Partnerships and S corporations may hold QSBS, but they function as conduits: the exclusion is ultimately claimed by the non-corporate partner or shareholder, who must have held an interest in the entity on the date the entity acquired the QSBS and at all times through the disposition. IRC §1202(g).

The limitation embedded in that rule is easy to miss. A partner’s share of the excludable gain is capped by the partner’s interest in the partnership at the time the partnership acquired the stock. A partner who is admitted after the fund purchases QSBS, or whose interest increases afterward, gets no §1202 benefit on the incremental interest. Fund documents rarely flag this, and investors rarely ask.

III. The Per-Issuer Cap

The exclusion is limited, per issuer, to the greater of ten times the taxpayer’s aggregate adjusted basis in stock of that issuer disposed of during the year or a dollar figure — $10 million for stock issued on or before July 4, 2025, and $15 million for stock issued thereafter. IRC

• 1202(b)(1). The dollar figure is reduced by eligible gain previously excluded with respect to the same issuer in prior years and is halved to $5 million for married taxpayers filing separately. IRC §1202(b)(3).

The 10x-basis alternative is underused. It is irrelevant to a founder who paid $1,000 for common stock but often controls where a client contributed appreciated property or converted an established business into C corporation form, because the basis in contributed property is measured at fair market value immediately after the contribution. IRC §1202(i)(1)(B).

IV. Redemptions — The Most Overlooked Disqualifier

Nothing in §1202 is more capable of quietly destroying an otherwise perfect QSBS position than a poorly timed stock repurchase. Under IRC §1202(c)(3)(A), stock is not QSBS if, at any time during the four-year period beginning two years before the issuance, the issuing corporation purchased any of its stock from the taxpayer or from a person related to the taxpayer within the meaning of §§267(b) or 707(b). Under §1202(c)(3)(B), stock is also disqualified if, during the two-year period beginning one year before the issuance, the corporation made one or more purchases of its stock having an aggregate value exceeding 5% of the aggregate value of all its stock as of the beginning of that period.

Treasury Regulation §1.1202-2 supplies the operative definitions and a set of exceptions, including redemptions incident to the termination of services, death, disability, mental incompetency, or divorce, and de minimis redemptions. These are the only regulations Treasury has ever promulgated under §1202, which is itself an indication of how much litigation risk the drafters saw in this area.

Two features of these rules make them genuinely dangerous. First, the lookback reaches backward as well as forward, so a founder buyback completed before a financing round can taint stock issued after it. Advisors who screen only for post-issuance events will miss this entirely. Second, the significant-redemption test under §1202(c)(3)(B) is measured at the corporate level and requires no relationship whatever between the redeemed holder and the taxpayer. A shareholder who had nothing to do with a buyback — who may not have known it occurred — can lose QSBS status because the company repurchased shares from someone else.

Ordinary-course corporate events must therefore be run through the redemption analysis before they close, not after: repurchasing a departing employee’s shares, a secondary tender, settling a dissenting shareholder, or recapitalizing in connection with a new round. Where the transaction is unavoidable, ask whether an exception in Treas. Reg. §1.1202-2 applies and whether a planned issuance can be moved outside the window.

V. Transfers and Tacking

The five-year clock begins at original issuance and is not restarted by every subsequent transfer. IRC §1202(h)(1) provides that in the case of a covered transfer, the transferee is treated as having acquired the stock in the same manner as the transferor and as having held it for the transferor’s holding period. The covered transfers are gifts, transfers at death, and distributions from a partnership to a partner. IRC §1202(h)(2)(A)–(C).

• Gift transfers. A donee steps into the donor’s shoes for both QSBS status and holding period. This is the mechanism that makes lifetime transfer planning possible.
• Partnership distributions. A partner receiving QSBS in a distribution tacks the partnership’s holding period, subject to the §1202(g) interest limitation discussed above.
• Transfers at death. QSBS receives a basis step-up to fair market value under IRC §1014, and under §1202(h)(2)(B) the transferee also tacks the decedent’s holding period, so QSBS status survives death.

That last point is often stated too simply. Where the estate or the heirs sell promptly, the step-up will usually eliminate the pre-death appreciation and render the §1202 exclusion largely redundant. The convergence is not universal, however. QSBS status retains real value where the heirs continue to hold, and the stock appreciates further, where the gain would have exceeded the per-issuer cap in any event, or where the client is domiciled in a state that declines to follow §1202 but does recognize the federal basis step-up. The lifetime-versus-testamentary comparison should be run on the client’s actual numbers rather than assumed in either direction.

VI. Multiplying the Cap

Because the per-issuer cap applies separately to each taxpayer, and because each properly structured non-grantor trust is a separate taxpayer for federal income tax purposes, a founder may transfer QSBS to multiple non-grantor trusts and family members and multiply the available exclusion. A single $15 million cap becomes several. This is the highest-value §1202 planning technique available, and it is also the one most frequently raised too late to implement.

The technique demands care. The trusts must be drafted to avoid grantor-trust treatment and administered consistently with that status. The form of the gift must be respected, which means completed transfers rather than paper recitals. Transfer tax cost must be weighed against income tax benefit. Most importantly, the planning belongs well in advance of any liquidity event; transfers executed while a letter of intent is circulating invite an assignment-of-income challenge.

Coming next in this series: Part IV — When the Structure Isn’t Right. Whether an LLC that has checked the box can issue QSBS and how the §1045 rollover preserves the benefit for holders who cannot wait five years.