QSBS Redemption Rules and Disqualification

Investors and founders in early-stage companies often focus on the tax benefits offered by Qualified Small Business Stock (QSBS). Governed by Section 1202 of the Internal Revenue Code, QSBS allows for a potential 100% exclusion of capital gains from federal income tax upon the sale of the stock. This incentive is designed to encourage investment in growing American businesses. To secure this benefit, the shareholder and the issuing C-corporation must satisfy a set of rules throughout the required five-year holding period.

An often overlooked aspect of maintaining QSBS eligibility involves corporate stock redemptions. A company’s decision to buy back its own shares can, in certain circumstances, disqualify otherwise eligible stock from receiving this favorable tax treatment. These anti-churning rules are complex and create potential pitfalls for shareholders and the corporation itself. Understanding these redemption rules is important for any stakeholder hoping to realize the full tax advantages of their investment.

The Foundation of Redemptions and QSBS

A stock redemption occurs when a corporation repurchases its own shares directly from a shareholder. This transaction reduces the number of outstanding shares and returns capital to the selling shareholder. While redemptions are a common corporate action, they are closely scrutinized under the QSBS framework. The intent behind the tax code is to stimulate economic growth by encouraging long-term capital investment into the operating needs of small businesses.

The tax code aims to ensure that new capital is used to fund business expansion and job creation. A redemption can be viewed as an action that runs counter to this objective, as it returns capital to shareholders rather than deploying it for growth. This has the appearance of “churning,” where a company might issue new stock to one investor while cashing out another, without any net increase in capital. To prevent this, the redemption rules were established as a safeguard.

Shareholder-Level Redemption Restrictions

A taxpayer’s stock will lose its QSBS status if the corporation repurchases shares from that same taxpayer or a “related person” within a specific four-year window. This testing period begins two years before the stock was issued to the taxpayer and ends two years after the issuance date.

The definition of a “related person” is broad and follows the guidelines in sections 267 and 707 of the Internal Revenue Code. This includes immediate family members such as spouses, children, grandchildren, parents, and siblings. It also extends to entities where the taxpayer has a significant ownership stake, such as a corporation or partnership where the taxpayer owns more than 50% of the value.

A de minimis exception provides some relief from this rule. According to Treasury Regulation Section 1.1202, a redemption from the taxpayer or a related person will not be disqualifying if the total amount paid for the stock does not exceed $10,000, and the shares purchased represent no more than 2% of the stock held by the taxpayer and all related persons. If a redemption exceeds either of these thresholds, the taxpayer’s stock issued within the four-year window is tainted.

For example, imagine a founder receives a new issuance of QSBS on June 1, 2025. If the corporation had redeemed shares from the founder’s father in July 2023, the founder’s new stock could be disqualified. The disqualification would depend on whether that 2023 redemption exceeded the $10,000 and 2% de minimis thresholds. This rule applies only to the specific taxpayer and their related parties.

Company-Level Significant Redemption Rules

Beyond the rules targeting redemptions from a specific taxpayer, a separate set of regulations can disqualify stock for all shareholders. These rules are triggered when the corporation engages in a “significant redemption,” regardless of who is being redeemed. This provision is designed to prevent a company from using new capital infusions to cash out large, early investors.

A redemption is considered significant if the aggregate value of the shares repurchased by the corporation exceeds 5% of the total value of all the corporation’s stock. This 5% test is measured against the value of the company’s stock at the beginning of a two-year testing period. This period covers the one year before the stock issuance and the one year after. If a significant redemption occurs within this window, all stock issued during that time may be disqualified.

A de minimis exception also applies to this rule. A redemption is not considered significant if the aggregate amount paid for the stock is $10,000 or less and represents 2% or less of all outstanding stock.

Consider a scenario where a startup issues new QSBS-eligible shares to employees on March 1, 2025. Six months later, the company facilitates a large buyback for an early venture capital fund. If the value of the shares redeemed from the fund exceeds 5% of the company’s total stock value as of March 1, 2024, the stock issued to the new employees would be disqualified. This occurs even though the employees are completely unrelated to the departing fund.

Permitted Redemption Exceptions

The Internal Revenue Code recognizes that not all redemptions are intended to circumvent the purpose of QSBS. Treasury regulations provide several exceptions that permit a corporation to buy back its stock without triggering a disqualifying event. These exceptions cover specific life and business events where a redemption is a practical necessity.

Permitted redemptions include:

• Termination of services: If a shareholder acquired stock in connection with performing services as an employee or director, the corporation can repurchase that stock incident to their retirement or other bona fide termination of services.
• Death of a shareholder: A company can buy back stock from a deceased shareholder’s estate or beneficiaries without causing a QSBS disqualification, which provides liquidity for the estate.
• Disability or mental incompetency: A company can repurchase shares from a shareholder who can no longer participate in the business for health reasons.
• Divorce: A stock purchase that is incident to a divorce, as defined under Section 1041, is disregarded for QSBS testing purposes.