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Highlights
- Starting on July 5, 2025, the One Big Beautiful Bill Act (OBBB) has amended Internal Revenue Code Section 1202 to provide additional benefits to owners of qualified small business stock (also known as QSBS within the meaning of Section 1202(c) of the Code). However, companies and investors should beware that the prior stock redemption rules continue to apply and could disallow QSBS benefits in certain fact patterns.
- Stock repurchases by a corporate issuer can disqualify QSBS status for a shareholder if the redemptions of that shareholder or related parties are more than a de minimis amount and occur over a four-year testing period. Separately, an issuing corporation can disqualify QSBS status for any shareholder who acquired purported QSBS within a two-year testing period if aggregate redemptions during the two-year period are more than a de minimis amount and exceed 5 percent of corporate equity value measured as of the beginning of the two-year period.
- Increased tax incentives under OBBB will put pressure on corporations to carefully monitor their QSBS compliance, especially if they engage in stock redemptions. U.S. Department of the Treasury regulations contain exceptions and de minimis rules to remove certain redemptions from the two-year and four-year tests noted above, but these exceptions can be limited in practice and require careful corporate-level monitoring to apply.
The One Big Beautiful Bill Act1 (OBBB) recently expanded the scope of the gain exclusion rules under Section 1202 of the Internal Revenue Code of 1986, as amended (the Code). As a result, emerging companies and their investors may be interested in increasing their use of qualified small business stock (QSBS) in order to offer the potential for capital gain exclusion on future sales of QSBS. Such taxpayers are advised that the redemption limitations of Code Section 1203(c)(3) (Redemption Limitations) remain unchanged and are therefore as likely as ever to spoil an otherwise valid QSBS issuance.
Relevant Law
The Redemption Limitations are generally intended to prevent taxpayers from converting non-QSBS into QSBS2 but apply with equal force where such a conversion is not intended. In other words, these rules are mechanical. They require companies and investors to check each issuance of purported QSBS over a period of time to make sure that both tests are satisfied.
The first test examines whether the holder of purported QSBS or any related party has engaged in any disqualifying redemptions of stock with the issuing company over a four-year testing period. Specifically, QSBS status of stock issued to a tested shareholder will be disqualified if the issuing corporation purchases, directly or indirectly, from the shareholder or any related person any of its own stock within the two-year period immediately before and after the issuance date of the tested stock (the Four-Year Rule).3
The second test is a two-year rule and reaches a broader group of shareholders. This test also examines each stock issuance separately and focuses on the one-year periods immediately before and after the issuance date. A stock issuance is disqualified from QSBS benefits if the issuing corporation engages in a significant redemption during this two-year period beginning on the date that is one year prior to the issuance of the purported QSBS that is being tested. A significant redemption means a redemption (or a series of redemptions) of stock of the issuing corporation from any person with value (determined at the time of the purchase(s)) exceeding, in the aggregate, 5 percent of the value of the company's entire stock value measured at the beginning of the two-year period (the Two-Year Rule).4
Both tests are applied on a rolling basis, using each tested stock issuance date as the key date from which to look backward and forward. These tests can be applied only if a party has access to sensitive data such as company stock value, stock ownership dates, the context and circumstances surrounding any redemption(s), and prior redemption history. In practice, this means that the company itself is typically the only party in a position to review and apply these tests, even though the risk of losing QSBS status under either test rests with the shareholder.
The Redemption Limitations create management hazards for a corporation's board and executive team trying to navigate continued QSBS qualification for existing shareholders while also managing new funding rounds and equity compensation grants. For example, if a significant redemption occurs, then the corporation could inadvertently disqualify QSBS status for recent stock acquirers. At the same time, a significant redemption may mean that the corporation will need to limit future equity financings and equity compensation grants for a period of time. In these cases, careful testing at the corporate level is important to ensure continued QSBS status of the current and future shareholder group.
Below is a summary of several other key points.
Related Person
Under the Two-Year Rule, all redemptions of stock over the testing period are taken into account in applying the test, and so there is no separate test for stock held by or redeemed from related persons. In contrast, under the Four-Year Rule, redemptions from only the taxpayer and persons who are related to the taxpayer are examined to determine if the test for that taxpayer is satisfied. A related person means any person treated as related under the rules contained in Sections 267(b) or 707(b) of the Code, including through controlled entities and family attribution.
Section 304 Redemptions
When a person controls two corporations and causes one such corporation to purchase the stock of the second corporation, Code Section 304(a) can cause the payment to be treated as either a dividend or a stock redemption. To the extent this kind of transaction is classified as a stock redemption, the Code counts the redemption when applying the Redemption Limitations, meaning that such redemptions may have the effect of disqualifying otherwise valid QSBS.5
De Minimis Exception
The Code is silent on the treatment of small redemptions, but the regulations (Treasury Regulations) under Section 1202(c)(3) of the Code add a de minimis exception to both the Two-Year Rule and Four-Year Rule whereby smaller redemptions are simply ignored when applying these tests.6
For the Four-Year Rule, a redemption is more than de minimis (and therefore may disqualify otherwise valid QSBS) only if the aggregate amount paid for the redeemed stock exceeds $10,000 and more than 2 percent of the stock (determined at the time of the redemption purchase(s)) held by the taxpayer and related persons is acquired by the issuing corporation during the four-year testing period.7 For purposes of determining whether the 2 percent limit is exceeded, the percentage of stock acquired from a taxpayer or related person is determined by dividing the redeemed stock's value (as of the time of the purchase) by the value (as of the same time) of all stock held directly or indirectly by the taxpayer and related persons immediately before the purchase.8
For the Two-Year Rule, a redemption of stock is more than de minimis (and therefore may disqualify otherwise valid QSBS) only if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of all outstanding company stock is purchased during the two-year testing period.9 To determine whether the 2 percent limit is exceeded, the percentage of stock acquired in a corporate repurchase is calculated by dividing the redeemed stock's value (as of the time of the redemption purchase(s)) by the value (as of the time of the purchase(s)) of all company-issued stock outstanding immediately before the purchase(s).10 Also, in applying the 2 percent exception (under either the Two-Year Rule or Four-Year Rule), the regulation states that if there are multiple corporate purchases, then, for purposes of the de minimis test, the percentage of stock acquired is the sum of the percentages determined for each separate purchase.11
Excluded Redemptions
The Treasury Regulations permit taxpayers to exclude certain redemptions entirely when applying the Redemption Limitation rules. The excluded transactions include redemptions made in the following circumstances (collectively, Involuntary Redemption Exceptions):12
- if the purchase is made in connection with the termination of services by an employee or director13 where the stock is purchased from such person incident to a person's retirement or other bona fide termination of such person's services (assuming the stock was also received in connection with the holder's provision of services)
- if the purchase is made from certain transferees of a decedent's stock after the decedent's death (if such redemption occurs within three years and nine months from the date of death)
- if the stock is purchased incident to the disability or mental incompetency of the selling shareholder
- if the stock is purchased incident to the divorce of the selling shareholder
The Involuntary Redemption Exceptions limit the draconian nature of the general redemption rules by carving out certain common circumstances where involuntary redemptions are required to be made. In addition, the Treasury Regulations exclude for purposes of determining whether the Redemption Limitations are violated any transfer of stock by a shareholder of the issuing corporation to an employee or independent contractor (or to a beneficiary of an employee or independent contractor) of the issuing corporation, even if the transaction is treated as a deemed redemption because the stock is treated as having first been transferred to the corporation under Treasury Regulations Section 1.83-6(d)(1), with the corporation treated as receiving cash from the transferee shareholder and paying such cash to the transferor shareholder for such stock (the Shareholder-Service Provider Exception).14 Notably, the Shareholder-Service Provider Exception and the Involuntary Redemption Exceptions are both applied without regard to the amount of the redemption or value of the issuing corporation.
Monitoring Stock Redemptions Post-OBBB
Although OBBB expanded the scope of corporations eligible to issue QSBS, it did not amend the Redemption Limitations. Thus, corporations that intend to issue QSBS must continue to ensure that no disqualifying redemptions have occurred within the relevant testing windows prior to issuing such stock and must additionally continue to monitor redemptions in the post-issuance period to ensure that no disqualifying redemptions are made within the relevant testing windows.
Helpfully, the Involuntary Redemption Exceptions and Shareholder-Service Provider Exception are both applied without regard to the amount of the redemption or value of the business at the time of redemption (or otherwise). Therefore, to the extent that a corporation issues purported QSBS and then anticipates one or more later redemptions within the relevant testing windows that will be covered by one of these exceptions, the corporation can rest assured that such redemption will not violate the Redemption Limitations.
On the other hand, if a corporation has redemptions within the testing windows that it either 1) intends to exclude under one of the de minimis exceptions or 2) intends to treat as a redemption that does not exceed the 5 percent limitation of the Significant Redemption Limitation, then it will need to determine the value of the business on multiple testing dates. For both the Two-Year Rule and Four-Year Rule, the de minimis exception is applied based on the value of the corporation's stock at the time of any redemption(s).15 In addition, to test whether a redemption (or a series of redemptions) is significant and violates the 5 percent threshold, the corporation will need to know the value of its stock as of the time of each redemption and the date one year prior to the issuance of the presumed QSBS.16 Multiple issuances of presumed QSBS or multiple redemptions within the relevant testing windows can, of course, require multiple valuations.
Below are several examples illustrating these rules.
Example 1 – Excluded Redemptions
Assume a corporation makes three issuances of purported QSBS to 1) an officer who is an employee of the corporation, 2) a member of the board of directors and 3) a part-time consultant. Also assume that in each case, the QSBS is issued as compensation for services and the recipients either make elections under Section 83(b) of the Code or the stock is not subject to a substantial risk of forfeiture within the meaning of such Code section. The consultant is not a W-2 employee and not a board member. One year later, the corporation terminates the services of all three individuals and, as part of these terminations, buys out their stock for $15,000 each. Are all three redemptions excluded from the Redemption Limitations?
Result. With respect to the officer and board member, yes; with respect to the consultant, the answer is unclear. First, note that each redemption is more than $10,000 and, therefore, none of them is excludable as a sub-$10,000 transaction.17 Second, the stock redemptions of both the officer and the director should be excluded under the Involuntary Redemption Exceptions, because 1) both persons acquired their QSBS in connection with the performance of services and 2) the repurchase of their stock is incident to their termination. Moreover, directors and employees are squarely covered by the termination of service Involuntary Redemption Exception.18 Note, however, that this conclusion is also dependent upon a complete termination of service and not simply a change of position or a reduction in each person's service level.19
However, there is not a clear exemption for the consultant who is neither a bona fide employee or director. The Treasury Regulations currently reserve the treatment of stock purchased from independent contractors, implying that the IRS may be receptive to finding that such a purchase in connection with a bona fide termination of a contractor's services fits within the exception.20 But in the absence of authoritative guidance specifically extending this exception to purchases of stock from independent contractors, taxpayers seeking to rely on this kind of argument in connection with the purchase of stock from a terminated independent contractor are advised that such position lacks specific support in the applicable regulations.
Example 2 – Applying the 2 Percent De Minimis Exception
On March 31, 2025, a corporation is formed and issues QSBS to the founder. Nine months later, on Dec. 31, 2025, the corporation issues common stock to a small group of individual investors (First Investor Group) for cash. The corporation is valued at $1 million at the closing of this December investor round. During the second quarter of 2026, the corporation redeems two different individuals from the First Investor Group, each for $25,000. Assume that neither of these redemptions qualifies for the Involuntary Redemption Exception, and each redeemed shareholder is completely bought out and holds no other equity in the company. Also, assume the two redeemed persons are not related to the founder or anyone else from the First Investor Group. The value of the corporation at the time of each redemption is estimated to be $2 million.
The corporation plans to issue QSBS in a second financing coming up, with an expected closing date of Dec. 31, 2026. The investors in the second financing (the Second Investor Group) will include some individuals from the First Investor Group but will exclude the two individuals who were redeemed in the second quarter of 2026, and other than the investors in the Second Investor Group who are also investors in the First Investor Group, none of the investors are related to each other or the founder. Assume that the pre-money equity value at the end of December is expected to be $10 million. What effect will the stock redemptions in the second quarter of 2026 have on the QSBS status of stock held by the founder and the remaining First Investor Group? Will the corporation be able to issue QSBS in its second financing at the end of 2026?
Founder's QSBS. The founder acquired his QSBS on March 31, 2025. Under the Two-Year Rule, the founder tests for any disqualifying redemptions in the one-year period before and after the founder's QSBS acquisition date. Because the two redemptions here occurred in the second quarter of 2026 – which is more than one year from the founder's March 31, 2025, QSBS purchase date – his original QSBS purchase upon the corporation's formation is not invalidated by the second quarter 2026 redemption under the Two-Year Rule. Therefore, the 2026 redemptions should have no effect on the founder's QSBS status. Also, note that the Four-Year Rule does not apply to the founder, because the founder's stock has not been redeemed and the two redeemed persons are not related to founder.
QSBS Issued to First Investor Group. The First Investor Group purchased their QSBS on Dec. 31, 2025. The redemptions occurred three months to six months later in the second quarter of 2026, which is within the one-year period after their stock purchase. Therefore, under the Two-Year Rule, these redemptions are relevant in testing for QSBS status of the entire First Investor Group. The Four-Year Rule does not apply, because the continuing shareholders in the First Investor Group were not related to the shareholders that are redeemed in the second quarter 2026 stock redemption.
Applying the 2 percent de minimis rule, each redemption corresponds to a percentage reduction of approximately 1.25 percent at the time it occurred. In other words, the de minimis threshold is tested by dividing the redeemed stock's value ($25,000) at the time of the redemption by the total value of the corporation's issued stock at the same time ($2 million). The incremental percentages are then added up to determine if the 2 percent threshold is met. Here, each purchase is under 2 percent when tested separately, but the two stock purchases together add up to 2.5 percent, which is more than 2 percent. Therefore, the de minimis rule does not shield these redemptions.
Next, the parties need to determine whether the 2.5 percent redemptions constitute a significant redemption, which would disallow QSBS status for all stock issued to the First Investor Group. A significant redemption means a redemption that exceeds 5 percent of the corporation's fair market value measured one year prior to the purported QSBS issuance date. It is unclear how the test would be applied because the stock was issued on Dec. 31, 2025, and one year prior to that date, the corporation did not yet exist. The Code and regulations are silent on how to apply the significant redemption rule in a fact pattern like this. The possible answers are either 1) the significant redemption rule does not apply at all when there is not a full one-year testing period and is therefore turned off for the First Investor Group, or 2) the significant redemption rule is applied on the oldest date of the corporation in the prior one-year period, which presumably here would be the corporation's March 31, 2025, incorporation date but might also be the date when the corporation first engaged in business. If the business was previously operated as a sole proprietorship or other form of entity, then the value of that business one year prior to the tested stock issuance might arguably be used. The regulations do not provide detail on this matter. But, it is clear that on one or more of these dates, the corporation had an enterprise value. Five percent of such value would mark the limit for stock redemptions as to corporate stock issued within the next one-year period. Of course, many startup companies have minimal or highly speculative value on their formation dates. But frequently, the value is low, and so 5 percent of a low startup value leads to a very low ceiling within which to conduct any redemptions of stock in the first year of a corporation's existence. In this example, the First Investor Group will face significant uncertainty on whether the stock they hold qualifies as QSBS. To avoid a significant redemption problem, they would need to argue that either 1) the significant redemption test does not apply at all, or 2) the significant redemption rule does apply but on the corporation's formation date (or start of business date) it had a value in excess of $1 million (i.e., 5 percent of $1 million would equal $50,000, and the second quarter 2026 redemptions had an aggregate value of exactly $50,000) – i.e., the same value it has nine months thereafter at the time of the Dec. 31, 2025, QSBS issuance to the First Investor Group. The uncertainties of valuation create material risk for this second position.
QSBS Issued in Second Financing. The parties need to apply the Two-Year Rule to the second financing. If we assume a second financing closing date of Dec. 31, 2026, the testing period that begins one year before that date includes the second quarter 2026 stock redemptions. As noted above, those two redemptions add up to 2.5 percent of the value of the corporation at the time of the second quarter 2026 redemptions, which is more than 2 percent and therefore not eligible for exclusion under the de minimis rule.
Next, the parties need to determine if the 2.5 percent worth of second quarter 2026 redemptions is treated as a significant redemption. The significant redemption rule is based on 5 percent of the corporation's equity value on the date that is one year prior to the tested QSBS issuance date. In this example, the date one year prior to the tested issuance date is Dec. 31, 2025. On that date, the corporation had a value of $1 million, and 5 percent of this value equals $50,000. Because the second quarter 2026 redemptions add up to exactly $50,000, the 5 percent threshold is not exceeded. Therefore, stock issued on Dec. 31, 2026, in the second financing is not prevented from qualifying as valid QSBS under the significant redemption limitation.
Note that the Four-Year Rule does not (yet) apply in this fact pattern because we are assuming that none of the investors in the second financing has engaged in a prior stock sale to the corporation (i.e., under the facts, the two redeemed shareholders from the First Investor Group are excluded in the second financing) nor are they related to the redeemed shareholders. However, the Four-Year Rule could apply going forward if one or more of the investors in the second financing is partially redeemed in the two-year period ending on Dec. 31, 2028.
Example 3 – The Founder Who Wants to Take Money off the Table
Assume a corporation will issue Series A preferred stock to new cash investors. At the same time, the founder of the corporation (holding common stock) would like to sell some of his shares for cash. The founder acquired his stock within the last two years. The investors approve the idea; however, none of them wants to purchase common stock directly from the founder, because they are concerned that this kind of cross purchase would not result in QSBS stock for the buyer.
But, assume that one of the parties (who is not a QSBS expert) is operating under the assumption that the founder can be redeemed for an amount just under 5 percent of the equity round's closing value. Under this thinking, if the company is valued at $5 million at the investment closing, then the parties could arrange for a redemption of Founder's stock in an amount of up to $250,000. Is this correct?
Result. No, the parties are mistaken. Each stock issuance is tested separately. The founder would lose QSBS status for his prior stock purchase under the Four-Year Rule. Meanwhile, the investors could also lose QSBS status if the proposed redemption amount was more than 5 percent of company value as of the testing date that falls one year prior to the Series A closing.
Founder's QSBS Position. The founder's stock was issued within the last two years, and now some of that stock is proposed to be redeemed by the corporation in connection with the preferred stock issuance. Under the Four-Year Rule, any redemption of founder's stock in the two-year period after his initial acquisition will disqualify all stock held by founder from QSBS treatment. The de minimis rule would not apply because if he is redeemed at just under 5 percent, this redemption would exceed the 2 percent de minimis limit. Therefore, because the proposed redemption falls within the two-year testing period and the de minimis rule does not apply, the founder's QSBS stock position would be compromised under this plan.
Investors' QSBS Position. Under the Two-Year Rule, a significant redemption in this fact pattern would be tested by first determining if the stock redeemed was kicked out of the calculation under the de minimis rule. As noted in the prior paragraph, the de minimis rule does not apply. Next, the corporation needs to check whether the dollar amount of the redemption exceeds 5 percent of company value measured one year prior to the Series A issuance date. Frequently, the parties will not know the value of the stock one year prior to a stock issuance date, and it will be hazardous to stake a valuation position for QSBS testing purposes based on prior estimates. Here, if the company was appreciating in prior periods, then 5 percent of the company's value measured one year ago could easily be less than $250,000. Given the uncertainties of value, it would be risky to make a large redemption of founder stock at the time of the Series A issuance.
Conclusion
Corporations issuing presumed QSBS in the wake of the OBBB must be cognizant of the Redemption Limitations and their capacity to invalidate an otherwise valid issuance of QSBS. The pre-issuance inquiry is fairly straightforward, since it requires the issuing corporation to ensure that it did not have any violating redemptions prior to issuing QSBS (which presumably is easier to determine than future redemptions, since their amount and existence is known). However, the corporation must also be careful to ensure that no violating redemptions are made within the applicable post-issuance testing windows. In this area, the Involuntary Redemption Exceptions, Shareholder-Service Provider Exception and de minimis exceptions are helpful, but these exceptions rely on a careful review of the underlying facts (e.g., for redemptions involving service providers) or a determination of corporate value based on multiple testing dates. As a general rule, proposed stock redemptions should be considered with care and permitted only if they align with the company's prior and future goals under Code Section 1202.
Footnotes
1 Public Law No: 119-21.
2 See H.R. Rep. No. 213, 103d Cong., 1st Sess., 523 (1993) (redemption provisions intended to prevent evasion).
3 Code Section 1202(c)(3)(A); Treasury Regulations Section 1.1202-2(a).
4 Code Section 1202(c)(3)(B); Treasury Regulations Section 1.1202-2(b).
5 Code Section 1202(c)(3)(C). Taxpayers transferring stock between controlled corporations within the relevant testing windows should be aware of this trap.
6 See Treasury Regulations Section 1.1202-2(a)(2) (related party redemption limitation de minimis rules); see also Treasury Regulations Section 1.1202-2(b)(2) (significant redemption limitation de minimis rules).
7 Treasury Regulations Section 1.1202-2(a)(2).
8 Id. If stock is acquired from the taxpayer or related persons in more than one transaction within the testing window, the percentage is determined by adding up the percentages as determined for each separate purchase.
9 Treasury Regulations Section 1.1202-2(b)(2).
10 Id. If stock is acquired in more than one transaction within the testing window, the percentage is determined by summing the percentages as determined for each separate purchase.
11 Treasury Regulations Section 1.1202-2(a)(2) and -2(b)(2) (last sentence).
12 Treasury Regulations Section 1.1202-2(d).
13 The Regulations currently reserve the treatment of stock redeemed from independent contractors in connection with the termination of a contractor's services. See Treasury Regulations Section 1.1202-2(d)(1)(ii). Thus, the potential application of this exception to stock redeemed from independent contractors is highly uncertain.
14 Treasury Regulations Section 1.1202-2(c).
15 See Treasury Regulations Section 1.1202-2(a)(2) (providing that for purposes of determining whether the 2 percent limit is exceeded for purposes of the Related Party Redemption Limitation, "[t]he percentage of stock acquired in any single purchase is determined by dividing the stock's value (as of the time of purchase) by the value (as of the time of purchase) of all stock held (directly or indirectly) by the taxpayer and related persons immediately before the purchase") (emphasis added); See also Id. at Section 1.1202-2(b)(2) (providing that for purposes of determining whether the 2 percent limit is exceeded for purposes of the Significant Redemption Limitation, "[t]he percentage of the stock acquired in any single purchase is determined by dividing the stock's value (as of the time of purchase) by the value (as of the time of purchase) of all stock outstanding immediately before the purchase.") (emphasis added).
16 Code Section 1202(c)(3)(B) (defining a violating significant redemption as "1 or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding five percent of the aggregate value of all of its stock as of [one year prior to the date of the issuance of the presumed QSBS].").
17 Note that the $10,000 threshold appears to apply on an aggregate basis. Thus, under both the Two-Year Rule and the Four-Year Rule, a redemption exceeds a de minimis amount if the aggregate amount paid for stock exceeds $10,000 and the 2 percent threshold is met. See Treasury Regulations Section 1.1202-(a)(2) and -2(b)(2)
18 Treasury Regulation Section 1.1202-2(d)(1)(i).
19 Regarding terminations, the regulations require either a retirement or other bona fide termination, which suggests that if a person merely reduces or changes his or her role, this exception does not apply. Treasury Regulation Section 1.1202-2(d)(1). The presence of the bona fide language also calls into question whether the nominal hiring and firing of a shareholder in connection with the purchase of their stock is sufficient to fit the redemption into the termination of service Involuntary Redemption Exception.
20 See 1.1202-2(d)(1)(ii). Per the preamble to these regulations, the Treasury Department reserved guidance on this issue because it wanted to consider more public comments on how to determine when an independent contractor has terminated. T.D. 8749, 62 FR 68166 (Dec. 31, 1997).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
