Many founders of start-up companies organize those businesses as C corporations for a variety of reasons. One of the most important reasons is the ability of those founders, and other shareholders receiving company stock for cash or services, to eliminate some or all of the federal capital gains on sales of up to $15 million of stock (or $10 million of stock acquired before July 5, 2025) issued to them, provided the stock otherwise meets the requirements for “qualified small business stock” (“QSBS”) under Section 1202 of the Internal Revenue Code (“Code”). Section 1202, however, must be analyzed in conjunction with other provisions of the Code, the Treasury Regulations thereunder, rulings of the Internal Revenue Service (“IRS” or the “Service”) and the common law in order to ensure that future plans of the business do not cause stock to lose its character as QSBS.

For example, as companies grow and change, founders and other company executives may want to add provisions to the terms of the stock they hold, typically issued as common stock, to prevent dilution of their ownership. Section 1202(h)(4)(A) permits stock issued in exchange for other stock in a tax-free reorganization to retain its character as QSBS and its original holding period. In other words, a tax-free recapitalization under Section 368(a)(1)(E) will permit the resulting new class of stock to qualify as QSBS. Section 1202(h)(4)(B), however, limits the gain exclusion to the gain that would have been recognized if the transaction wasn’t tax free under Code Section 351 or Code Section 368, if the company no longer meets the requirements to be a qualified small business at the time of the transaction, particularly the $75 million aggregate gross assets threshold of Section 1202(d)(1)(A) (the “Freezing Rule”). On the other hand, if the corporation’s aggregate gross assets are less than $75 million (or $50 million before July 5, 2025) at the time of the recapitalization, the Freezing Rule clearly would not apply. Some even posit that Code Section 1202(h)(3), which provides that rules similar to the rules of Code Section 1244(d)(2) shall apply for purposes of Section 1202, allows Section 1202 to be interpreted in such a way that the Freezing Rule would not limit the excludable gain if the stock given up in the exchange was received at a time when the aggregate gross assets test was met.

Tax-Free Recapitalizations and QSBS Preservation

While it is helpful to know that corporations can undergo a tax-free recapitalization of their QSBS under Code Section 368 without causing that stock to lose its character as QSBS or triggering application of the Freezing Rule, the other requirements for a tax-free reorganization in other provisions of the Code, the regulations and the common law still must be met. For instance, Section 305 can operate to cause otherwise tax-free reorganizations to become taxable under certain circumstances. Section 305(c) and the regulations provide that a recapitalization (whether or not an isolated transaction) will be deemed to result in a distribution to which Section 301 applies if (i) it is pursuant to a plan to periodically increase a shareholder's proportionate interest in the assets or earnings and profits of the corporation, or (ii) a shareholder owning preferred stock with dividends in arrears exchanges his stock for other stock and, as a result, increases his proportionate interest in the assets or earnings and profits of the corporation. See Treas. Reg. §1.305-7(c)(1); Prop. Reg. §1.305-7(d)(1)(i). Although no specific authority on this point exists, a recapitalization of QSBS resulting in a taxable dividend under Section 305(c) runs the risk of the original QSBS no longer qualifying as QSBS under Section 1202(h)(4)(A).

Planning Considerations and IRS Guidance

All is not lost, however, because in the past the IRS has focused on the word “periodically” in the regulations, and issued rulings that isolated transactions that have a bona fide business purpose and aren’t pursuant to a plan to periodically increase a shareholder’s interest in the assets or earnings and profits of the corporation are tax-free recapitalizations and don’t give rise to a taxable stock dividend. In addition, the regulations also provide that changes in the conversion price of convertible preferred stock under a bona fide, reasonable adjustment formula which has the effect of preventing dilution of the interest of the holders of such stock (or securities) will not be considered to result in a deemed distribution of stock. See Treas. Reg. §1.305-7(b)(1).

In short, there are planning opportunities for legacy stockholders of companies issuing additional stock to preserve QSBS treatment for their existing stock. It is critical, however, to consult a tax advisor to analyze any proposed recapitalization under not only Section 1202, but the other provisions of the Code, as well as Treasury Regulations and IRS rulings, relating to tax-free reorganizations, to ensure that an otherwise tax-free transaction not only doesn’t become taxable, but also doesn’t jeopardize QSBS treatment for that existing stock.

1. The One Big Beautiful Bill Act (OBBBA) was enacted on July 4, 2025, which created several significant benefits to taxpayers (See https://darroweverett.com/one-big-beautiful-bill-business-tax-legal-analysis-updates/)
2. References in this DE Insight to sections are to sections of the Internal Revenue Code of 1986, as amended, unless otherwise indicated.
3. Under Section 301, the deemed distribution will be taxable as a dividend to the extent of the corporation's earnings and profits.
4. See, e.g., PLRs 8136094 (exchange of common stock for preferred stock to encourage the interest of the taxpayers’ sons in the business, to provide them with a more direct interest in the future growth of the business and to facilitate the ultimate transfer of the business to them, qualified as a tax-free E reorganization), 9819031 (a closely held corporation’s issuance of new class of nonvoting common stock to be exchanged for existing nonvoting common in order to fund charitable lead annuity trusts will not be treated as distribution to shareholders) and 200017034 (exchange of a closely held company’s stock in order to increase an ESOP’s interest would be a tax-free reorganization).