QSBS Stock Acquisition Rules: Original Issue and Redemption Restrictions

Understanding the nuances of Qualified Small Business Stock (QSBS) acquisition and the applicable restrictions is essential for maximizing tax benefits under Section 1202 of the Internal Revenue Code (IRC). This analysis delves into the critical requirements and restrictions that affect QSBS, particularly focusing on the original issue requirement and the implications of corporate redemptions.

Original Issue Requirement

For stock to qualify as QSBS, it must be acquired at its original issue. This acquisition can occur directly from the issuing corporation or through an underwriter, and can be in exchange for money, other property (excluding stock), or as compensation for services provided to the corporation (excluding underwriting services as specified in IRC §1202(c)(1)(B)). It is crucial to note that stock purchased on the secondary market does not qualify as QSBS, regardless of whether the issuing company meets the criteria of a qualified small business.

What Constitutes Original Issue?

The term "original issue" refers to stock being issued directly by the corporation to the taxpayer or through an underwriter at the initial offering. This definition specifically excludes:

• Stock purchased from another shareholder,
• Stock transactions on stock exchanges,
• Acquisitions in secondary market transactions,
• Any stock transfers that do not preserve QSBS status under Section 1202(h).

Acquisition Through an Underwriter

When stock is acquired through an underwriter during its original issuance, it qualifies as QSBS under IRC §1202(c)(1)(B). In this context, an underwriter is defined as a person who purchases stock from the issuer primarily for distribution or participates directly in the stock's distribution process.

Redemption Restrictions

Regulation 1.1202-2 offers detailed guidance on how redemptions can impact the qualification of stock as QSBS.

Redemptions from Taxpayer or Related Persons

A taxpayer's acquired stock will not qualify as QSBS if, within the four-year period starting two years before the stock's issuance, the issuing corporation repurchases more than a de minimis amount of its stock from the taxpayer or a related person (as defined under Section 267(b) or 707(b)). The criteria for exceeding a de minimis amount are:

• The aggregate payment for the stock surpasses $10,000,
• The repurchased stock constitutes more than 2% of the stock held by the taxpayer and related persons.

Significant Redemptions

Additionally, if the issuing corporation buys back its stock, amounting to more than 5% of all its stock's aggregate value at the onset of the two-year period starting one year before the stock's issuance, the stock issued will not qualify as QSBS. The de minimis rules for this scenario mirror those of redemptions from taxpayers or related persons.

Transactions Treated as Redemptions

Certain transactions, such as those treated under Section 304(a) as a distribution in redemption of stock, are considered as the corporation purchasing its stock. This rule aims to prevent corporations from structuring transactions in ways that might circumvent the redemption rules.

Exceptions to Redemption Rules

Certain redemptions are not considered disqualifying under Regulation 1.1202-2, including transfers by shareholders to employees, redemptions incident to termination of services, death, disability or mental incompetency, and divorce. These exceptions are crucial for maintaining the flexibility and fairness of the QSBS provisions, allowing for normal life and business events without penalizing the stockholders.

Stock Acquisition for Services and Property

Stock acquired as compensation for services (excluding underwriting), if acquired at original issue, qualifies as QSBS under IRC §1202(c)(1)(B)(ii). Similarly, stock acquired in exchange for money or other property (not including stock) also qualifies if acquired at original issue as per IRC §1202(c)(1)(B)(i).

Section 351 Exchanges and Reorganizations

Special rules under Section 1202(h)(4) apply to stock acquired in Section 351 exchanges and reorganizations:

• Section 351 Exchanges: If QSBS is exchanged for other stock in a Section 351 transaction, the new stock is treated as QSBS acquired on the date the exchanged stock was first acquired, provided the issuing corporation post-transaction controls the corporation whose stock was exchanged.
• Reorganizations: Similar rules apply to reorganizations under Section 368, though limitations apply unless the new stock is issued by a corporation that qualifies as a small business at the time of the transfer.

Transfers That Preserve QSBS Status

Section 1202(h) outlines that certain transfers such as gifts, death transfers, and certain partnership distributions preserve QSBS status. It treats the transferee as having acquired the stock in the same manner as the transferor and as having held it during the period it was held by the transferor.

Key Takeaways

1. Original issue is required: Direct acquisition from the corporation or through an underwriter at original issuance is necessary.
2. Secondary market purchases don't qualify: Only primary market acquisitions qualify.
3. Redemption restrictions are strict: Redemptions can disqualify stock, with specific exceptions allowed.
4. Exceptions exist: Certain life and business events do not trigger disqualification.
5. Services qualify: Compensation in the form of stock must be at original issue.
6. Transfers preserve status: Certain transfers do not disrupt QSBS status.
7. Section 351/reorganizations: Special rules ensure continuity of QSBS status in corporate transactions.

Sources and Citations

• IRC Section 1202(c)(1)(B): Original issue requirement
• IRC Section 1202(c)(3): Redemption restrictions
• Reg. 1.1202-2: Qualified small business stock; effect of redemptions
• IRC Section 1202(h): Transfers that preserve QSBS status
• IRC Section 1202(h)(4): Section 351 exchanges and reorganizations

Verification Date: January 2025

Note: This page reflects the law as of January 2025. The original issue requirement and redemption restrictions are strictly enforced. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding stock acquisition methods and redemption issues.