Common Mistakes and Misconceptions Regarding Qualified Small Business Stock (QSBS) Under Section 1202 – How Tax Works
Jan 20, 2026
In episode 44 of How Tax Works, Matt Foreman discusses common mistakes, misconceptions, and missteps involving qualified small business stock (QSBS) under section 1202, including exclusion stacking, state issues, the use of partnerships, and other common problems.
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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.
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Transcript:
**This transcript has been prepared automatically by AI and may contain inaccuracies**
Mathew Foreman [00:00:00]:
Foreign. Hello and welcome to the 44th episode of How Tax Works. I’m Mathew Foreman. In this episode I’ll discuss common mistakes and misconceptions under section 1202 of the Internal Revenue Code. It’s a common, you know, mistakes misconceptions of only qualified small business Stock or Q USBs. How tax works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney.
Mathew Foreman [00:00:35]:
How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. A few administrative things, right? New episodes every two weeks. The next episode is going to talk about stock sales taxes, asset sales, f. Re org selling, wholly owned subsidiaries under and also 338g 3038h 10 and 336e the various elections. Right. If you have any questions, comments or constructive criticism, if you have any topics you want me to cover that are similar, I’ll listen to it. I’ll consider it. But don’t necessarily say I’m going to do it.
Mathew Foreman [00:01:11]:
Right. And you know, upcoming some upcoming webinars and speaking engagements. I think one in January 2, February, and then I have my webinars that I’m going to start probably in late April. I have to figure out the exact, exact timing on that variety of topics. So first, you know, what are we discussing? Right? Common mistakes, misconceptions under section 1202 of the Internal Revenue Code qualifies or business stock is a really important one because it leads to a question of why do we care? Like, why is this important? And the reason that we care, the reason that’s important is that you have a possible tax rate of 0%. In theory, the best possible tax rate. Not entirely right. You know, with things like the earned income credit, child income tax credit, things like that, you can theoretically have tax rates below zero for the vast majority of taxpayers.
Mathew Foreman [00:02:01]:
This is, this is the best one you can get. This is the zero tax rate, which is pretty darn good, especially since these tend to be larger exits. So getting the rates down really gives you a very big dollar. Before I really kind of get into, you know, everything that I’m doing and what the common mistakes and misconceptions are, I do want to go through some of the, what I’m going to call general requirements first, you know, generally speaking, right. Non corporate taxpayer, you can exclude between 50 and 75% of the gain Realized, depending on some factors that I’ll talk about. On the sale or exchange of qualified small business stock, you have to acquire the stock after August 10, 1993, and you have to hold the stock for a period of at least three years, possibly at least five years. It depends on a variety of factors that I’ll talk about in a moment. The exclusion itself.
Mathew Foreman [00:02:52]:
So the amount that’s not taxed is generally 10 million. In a couple years you’ll see some that are be 15 million, but they’re really seven and a half. I’ll talk about that later. And it’s the greater of the 10 or 15 million or 10 times the taxpayer’s basis. It’s important to note that basis is not tax basis. They’re generally the same, but basis is actually fair market value or book basis at the time of contribution or different things. Right. So I think it’s really important to note that people say, oh, you know, I contributed property, it had a value of $8 million, but it had like, you know, basis of $300.
Mathew Foreman [00:03:29]:
So I’m just going to get the, I’m just going to get the 10 or 15 million. That’s not necessarily true. And I think it’s really important for you as a taxpayer, as an advisor, whatever, to understand that the words that are used do not always have their common meaning. And I always talk about this in the context of qualified small business stock, that you have to look at the words as they’re used and look at the examples as they’re used to understand what they mean. You can’t necessarily just look at the words and say, oh, I know exactly what that means. Nothing to worry about. So generally speaking, Most people get 10 or 15 million. Like I said, there’s ways to get more.
Mathew Foreman [00:04:04]:
There’s stacking, which I’m really not going to talk about here. I talked about it on a different episode of the podcast 17, 18, 19. So it’s probably episode 19 when I discussed it at high level. At some point I’ll do a little more thorough of one, but maybe not, I don’t know. I’m not sure it’s a full episode. But it’s a, it’s a concept. It’s something we do, something we see and it’s something that can be taken very seriously because it can really, really increase the exclusion amount. So the important thing to note is the stock.
Mathew Foreman [00:04:31]:
The first thing I always talk about is the stock issuance dates. I’m not going to get into the common ones and the issues, the things really do to the blocking and tackling of it. Right. So any stock that was issued or which I use the word granted. Right. There’s authorized and there’s issued. Authorized is how many you can issue. Issued is how many you’ve actually issued and when.
Mathew Foreman [00:04:47]:
If it was issued before or granted or sold before 8-11-93, not eligible. Generally, the exclusion amount if you received the stock between 8-11-93 through February 7, 2009, 50% exclusion, February 18, 2009 through September 27, 2010, 75% exclusion. And those are relevant because those are the dates of implementation of different passage of different bills. So it makes it a little harder for people to game it a little. And then September 27, 2010 and thereafter is 100% exclusion, unless it was issued after July 3, 2025. And then the exclusion amount depends upon how long that you held it. Right. So if you held it for three years, 50% exclusion, four years, 75% exclusion, and five years is a 100% exclusion, full exclusion.
Mathew Foreman [00:05:35]:
So it’s never worse than before, but could be better. Right. 50% exclusion at three years. You know, you do run into situations. I’ve run into them where people have hit four and a half years. And so that’s really important to note that, you know, it gets better. Right. So there are four basic requirements that, you know, you hit for qualifiers for business stock that have to be met.
Mathew Foreman [00:05:58]:
Domestic C Corp. So foreign corps no go. Must be held. Must be held by an individual US Person. So foreign individuals are not relevant. But if you’re not a U.S. person, you don’t really care. You get the same functional benefit anyway in the US Just how the tax system is structured.
Mathew Foreman [00:06:13]:
If you don’t know what I’m talking about, you can email me about it. I’ll explain it more in more detail. The gross assets of the company are. Cannot exceed 50 million. It is gross assets, not net. So once a company hits a certain threshold, it’s enough. Now it could be 75 million for companies where the stock was granted after July 3, 2025. One thing that does happen with this is sometimes they’ll, you know, do a raise at 45 million, not 60 million or 55.
Mathew Foreman [00:06:40]:
Now they’re just going to move up that bar. I’m not really totally sure it matters that much. The active business, right. The corporation must use at least 80% of its assets by value in the active conduct of one or more trader businesses. The trader businesses must be qualified. You know, I refer to as the active trade or business requirement. The trader business is any Trader business other than certain ones with a list. Basically it’s, it’s consulting or service businesses, banking and other finance, finance, farming businesses, production or extraction of oil and gas and lodging or restaurant businesses.
Mathew Foreman [00:07:14]:
No more than 10% of the assets can consist of real estate unless the real estate is using the active trader business. So if you have, you know, for example, a widget factory, real estate’s totally fine. If you just happen to hold real estate, not so much. Right. And no more than 10% of the assets can consist of stock or securities unless the stock or securities are in an asset are in a subsidiary corporation. There’s also a two year, what’s called a drawdown rule for cash. A lot of companies, you know, they raise cash, they use it over a period of time. You know, don’t, don’t, don’t, don’t carry cash.
Mathew Foreman [00:07:46]:
If you carry too much cash and you’re not using it in the business and slowly burning through it, that can actually make you not a qualified small business. So it’s really important to note for that. So I think that’s really important thing. We’re going to take a bit of an early break here for some music. We’re going to come back and start in the common misconceptions in the state. All right, hope you enjoyed the music. So we’re going to talk about some common mistakes, misconceptions. I have seven that I’m going to go through.
Mathew Foreman [00:08:31]:
I could probably do 20 to be honest, you know, because there’s just a lot of things that people get and just misunderstand. It’s a quirky section. And in doing these seven, I just want to make one thing clear. And I really mean this is don’t read into the code section what’s not there. Don’t read into the regs what’s not there. And make sure to fully understand what the code says and what it does not say. Right. So the seven are contribution to a partnership using grantor, trust, tax free mergers, original issuance and redemption issues.
Mathew Foreman [00:09:00]:
You live in New Jersey or California. Acquired stock before 97, sold before five, maybe three, maybe so five years. Okay, so those are the important ones. So common misconceptions and mistakes. Contribution into a partnership. Right. Stock is contributing to a partnership is not QSP stock in the hands of the partnership. And that’s under Treasury Reg.
Mathew Foreman [00:09:21]:
Sections 1.10451 F. And the example under 1.10451 I example 12 I should know. And it’s really important that these code these, these treasure regulation Sections do not have any deference without Chevron deference. There is no deference whatsoever for these code sections, for these sections of the treasury regs. So I’m not really totally sure it’s true. Naturally false, but doesn’t say it has. Right, right. 721 itself does not disqualify as how I view it.
Mathew Foreman [00:09:53]:
But the QSB stock, if sold in the hands of partnership, is not the. The functional reason for this is what the drafters were clearly concerned about is that someone would have a partnership, they sell or take investment in the partnership, and someone would invest in it to use it as a splitter for QSBs. And so they’re concerned about it. So they kind of alluded to it in the code, but they really made it pretty clear in the treasury regulations. I’m of the opinion that it’s not as strongly worded as it could be to actually do what it is, but that doesn’t mean you should ever put it into a partnership anyway. You could be, you know, arguing pretty uphill in an audit, litigating it. And again, you know, look like this is a large amount of money that you could be saving in tax. So I really want people to be serious and focus on the fact that you want to take this in a way that that’s gonna be beneficial for you.
Mathew Foreman [00:10:43]:
Okay? Don’t put into a partnership the premise of the partnership. Let’s just say, because you can invest through a partnership, that’s not a problem. Let’s say two people put a hundred dollars into a partnership, they buy stock usps, you know, they get the exclusion. Right? That’s fine. However, if partway through one were to leave the partnership and the entity were to disregard, there’s a very, you know, you only get. And they just walked away, right? They said, oh, it’s worth nothing. And eventually it wasn’t. Right? Whatever.
Mathew Foreman [00:11:08]:
They would only get. The person who holds on to it will only get half of that gain as qsbs, because it started in a partnership. So the partnership itself actually caps the gain. So I think it’s really important to think through. What are you trying to do? What are you trying to say? What’s the rule? How does the rule function? The 721 doesn’t do it. It’s just that it’s not. If held by the partnership, it’s not. QSPs, not qualified for business stock.
Mathew Foreman [00:11:29]:
So I think that’s a really important one to think about, to know how it works and to work through. Second one, using grantor trust But I get this way more often than you think. But you know, look like what people do is they want to stack, right? So they’re like, all right, well you know, we’re gonna do a series of grand tour trusts and you know, when I die it’s gonna go to my kids and this will be great. And you know, look like QRS is kind of pointless after death because you already got the step up under 1014, so there’s no real point in that. So what you want to do is they say okay, well they put in the grand tour trust and it’s like, all right, well it doesn’t actually help you because you still hold on to it. It’s still in your estate and you don’t get an extra one. It’s not a separate taxpayer, you know. So what happens is I see is not as much as straight up grantor trust.
Mathew Foreman [00:12:09]:
I have seen that, but I’ve seen a bunch of idiots intentionally defective grantor trust. So for income taxes, grantor for estate tax, it’s out of the estate and that’s great. I guess it’s kind of the worst of both worlds because you’re not stacking. So it’s staying within but then the assets out. Right. It’s a disregarded entity. Right. So a disregarded entity.
Mathew Foreman [00:12:29]:
They’re not separate taxpayers. So no transfer actually occurred for income tax purposes. Bunch of case sites you can get on that. Nothing directly on this point, but the general idea of it, right, it’s, it’s, you know how to do it. The appeal of James Dobson. 1 BTA 1082 Revenue Ruling 55 77. Of course, Eisner v. Macomber.
Mathew Foreman [00:12:48]:
If you’ve ever taken a basic federal income tax class, you have less likely encountered that class. 252, that case. Excuse me. 252 U.S. 189, 1920 case. Never a good sign when a 1920 case says you’re wrong. What I do see sometimes is people do certain grand tour trust have certain benefits but they don’t retain enough control intentionally. They give it away so then it becomes non grantor.
Mathew Foreman [00:13:10]:
Or they do something that they intend to be a non grantor trust but they retain too much control so it remains grantor. The analogy I always use is the pre check the box regiment the more two of four. So you know, you want it to be more non grantor than grantor. But really be careful. You know, exclusions are taxpayers have to have to beat, have to show the burden. So I really want people to make sure to get this right. You know, the next one is kind of an interesting one that I run into from time to time. It often occurs in the context of when there’s a merger of different companies and things like that.
Mathew Foreman [00:13:47]:
Sometimes it’s good and sometimes it’s bad. And the tax free merger is a way you can intentionally trigger via taxable transaction to use exclusion. So you don’t, you intentionally don’t use a tax free merger. That’s when you can do. But in the tax free context, which would of course then trigger, in the tax free context if a merger is not non taxable, so it is a taxable transaction that would just trigger, you get exclusion. What I see a bunch of times is companies that have gone three or four years and a company comes along and says, hey, we want to, you know, we want to buy your stock and it’s a public company. You know, I always use Google as an example, but you can kind of pick whatever you want. And they said, you know, we’d like to give you some stock, some cash.
Mathew Foreman [00:14:26]:
And I tell them, look, take all stock, 100% stock A. It’ll probably kick up the price a little bit because I don’t have to use cash for it. Right. Other than, you know, service fees and professional fees. And so what happens is you essentially you transfer the stock to another corporation which is tax free under section 351 or 368, either one works and the stock you receive does not qualify as qualified sole business stock. So the exclusion amount is fixed to the exclusion amount at the time of the merger contribution. The exclusion is not realized until the sale. Right.
Mathew Foreman [00:14:57]:
The eventual sale of in this case the public publico stock. Right. And that’s 1202 H4. Cap A and cap B go through the rules that you have to meet for that. What’s really nice about that, and this is why I sort of like really highlighted is you see this a bunch with companies that are three or four years in, so they’re not at the full exclusion. This just says, okay, if you hold the public company stock for another three, four years, whatever, then you’re fine. Then you can sell that public company Stock and get QSBs really can come in handy and come in in a beneficial way. So you know, there’s two kind of questions that happen about that.
Mathew Foreman [00:15:33]:
What if both C Corps are QSB at the time of the merger, but after the consolidation they meet the they exceed the asset test, right? So they both have $40 million of assets. After the merger they’re at 80. Right. The resulting company is not QSB. Do you have two exclusions or one. Right. Do you get one from each? How is it? I tell people that I think the answer is too. I don’t actually know and I don’t think anyone does.
Mathew Foreman [00:15:55]:
And IRS won’t give you a revenue ruling on it. So I think it’s really, really, really important to note what you want to do. So I’ve advised clients in this context to keep the company separate, don’t merge them together so that you don’t cross over. So you still have two exclusions because it’s two companies. Right. The next one’s really an interesting one. What if 1202 is repealed? Obviously people say, oh, it’s a permanent code section. And I always point out to people that, well, 174 immediate expensing was permanent until it was made temporary.
Mathew Foreman [00:16:25]:
Right. So permanent. Temporary. Temporary is permanent. So you really can’t rely on that. What happens if it’s repealed in between? Right. In between the 351 or 368 and then the eventual one. And the answer is, I’m not really sure.
Mathew Foreman [00:16:36]:
I think you lose it. I think you lose it because the exclusion no longer exists. But it’s an interesting question. I’d love to research it more fully. Just haven’t really sat down and done it. So I think that’s a really important one to go through. All right, we’re going to do a little more a second break then. Then bring it on home with the last bit.
Mathew Foreman [00:17:14]:
Okay, welcome back. So the next one I’m going to talk about is original issuance and redemptions. The stock must be acquired in an original issuance, which means it’s from the. The issuing corp. Itself and not a subsequent sale. So if someone holds it and sells it to, you know, third party or another shareholder or whatever, that stock that was sold, that’s no longer qsbs. So what someone sort of thought of is, well, what if I take the QSBS stock and it’s redeemed by the company and then the company sells it to someone else. Right.
Mathew Foreman [00:17:48]:
And you know, obviously Congress, you know, I’m not going to say they’re the best, but they figured that one out, right? They’re like, you know, was not born yesterday. Right. So what happens is they banned it. They prevent it in two, met with two mechanisms. One is what’s called a related party record, related party redemption, which is a related party under 267B or 707B. I’m not going to Go into it what related party is. But there’s a test for for it. And basically if you hit the requirements and you are a related party redemption two years before and two years after the redemption.
Mathew Foreman [00:18:24]:
So it’s really four years plus one day. Right. So if the redemption happens on January 1st of year three, it would block out all of year one and two. Then year three, rest of year four and January 1st of year five, it would give you that extra day. Anything that was any stock that was acquired that would otherwise be an original issuance is no longer QSBS no longer qualifying. Small business stock. 1202 C3 Cap A goes through that really important one. There is a de minimis exception that I’m going to go through but it’s really important.
Mathew Foreman [00:18:54]:
The other one is what’s called a significant redemption. They’re less concerned if they’re not related parties. Basically it’s one year before and after the redemption. It’s not qsps stock. That’s 1202 C3 cap B and that one is so again January 1st year three. So it’s going to knock out all of year two, all of your three and January 1st of year four. Okay. So that’s, that’s how the numbers end up working out.
Mathew Foreman [00:19:19]:
It’s a really important one. It can be big. And for that one, you know, basically the way the math works for the, for the redemption rules is that the fair market value of the redeemed stock at the time of the redemption cannot exceed 5% of the fair market value of the stock at the beginning of the you know, two year period. One year before, one year after. So if the company undergoes a significant increase in value, you might have a problem and that’s really important. I’ve seen this in the context a few times in the context of like bankruptcy where there is basically a redemption as a result of bankruptcy and how much people buy end up buying the stock back for can really matter. Really really really matter. So it can come up pretty importantly normally in this one this is where I make fun of New Jersey, but I actually think New Jersey now I use, I want to say does not decouple but coupled I don’t know the right word but I think it’s really important that a number of states don’t conform with this right.
Mathew Foreman [00:20:18]:
So I think Massachusetts 50% Hawaii, Wisconsin are 50% too. California does not conform. Couple other states are not total confirmation. So even though you might federally have no tax, some states might, might be taxable. So just watch out for that. You know I’ve run into it. They’re like, what can I do? Can I move states? It’s like it’s kind of already too late to move. You could, you know, the state’s probably going to say no, and then you kind of have to stay there.
Mathew Foreman [00:20:40]:
There are people like, oh, I’m going to move for like three weeks and then move back. And I’m like, really? Does that really work? Do you really think that works? The next one I always talk about is acquiring the stock in 1997. And people always say, well, it’s worse if you acquire it before. And that’s. That’s before 93 and August 11, 93. And that’s true. That’s totally true. What do I always want to point out to people, and I think this is like, really, really important is if you acquire the stock in 1997, for example, you have a 50% exclusion.
Mathew Foreman [00:21:09]:
So people get it and then they’re like, okay, well, it’s 50% exclusion, you know, 23.8%. And I’m like, well, sort of. Right. So what happens is federal and state, you have half the rate. And I think it’s really important to take it because what happens is it’s not the 23.8% that you think it is. What actually happens is it kicks the rate up for the non excluded portion to the highest capital gains rate that exists, which is 28%. So it’s a 31.8% rate divided by two puts you at 15.9, 15.9 and 23.8. Look, obviously it’s much better.
Mathew Foreman [00:21:44]:
It’s about 8% difference, but it’s not that far off. It’s still a pretty high rate. Right. So people, you know, maybe it’s better just elect s and sell the assets and get a higher buyout. Right? So it depends. And I think that’s really important. I think it’s really important to know. And this is going to become a big thing because everybody will hold it for three years and say, oh, I live for three years. I get 50%.
Mathew Foreman [00:22:04]:
And I’m gonna say, yeah, but the rate’s 15, 9. You know, it’s not. It’s not, you know, 12, 13%. You know, 12%, right. 23.8 is 11, 9. It’s a higher rate. Right. And if you held it for the period between, you know, February 18, 2009 through September 27, 2010, that is a 75% exclusion.
Mathew Foreman [00:22:26]:
31.8%. Right. So that. That’s still a decent rate. That’s still over 10%, so, you know, or around 10%, so it’s still a decent one. That’s also going to kind of creep its way up and be problematic for all the people who bought it. You know, the three, four, five year thing, depending on how long you hold, held it, that’s going to sort of punctuate into it and people are going to have it and they’re going to say, oh, three years, I got my five, you know, my, my exclusion. I hit the three years and I’m going to have the super fun thing of explaining to them, no, you got, you know, 50% exclusion.
Mathew Foreman [00:22:57]:
So the truth is it’s not that great. And then the buyer loses depreciation, amortization. So they’re probably going to lower your purchase price and you may have been better off just being a partnership to start, right, to get, to get a higher purchase price. And people ask me, and this is where I’m going to kind of bring it home is do people, do buyers really lower the purchase price? If it’s qsbs, the answer is yes and no. Sometimes they just say, look like we’re just going to punt on it and that’s it. And that usually means you could have negotiated a higher price. A lot of times they say, especially if they don’t know going in that it’s QSPs, they’ll say, okay, well we want to lower it based on the value. And then you’re arguing about the time value of money, effective tax rate, state tax rates, whether there’s other issues, et cetera, et cetera, and then depreciation, amortization, things like that.
Mathew Foreman [00:23:41]:
And so I always tell people, and I’m going to talk about this in a later podcast at some point, that like chasing QSBs isn’t always the way to go. It is not always the thing to do because sometimes, especially for businesses that are profitable, right? If you qualify for QSBs, you qualify under 199 cap. A. A lot of states have passed Serenity Taxes PTE. And I think it’s really, really, really, really, really important to do an overall math. You know, I, I somewhat frequent basis get brought into conversations between accountants, financial advisors, business lawyers, et cetera. I don’t say to mediate, but to sort of walk them through what is the correct math, what is the risk? And it’s a, it’s a risk. USPS is a significant risk.
Mathew Foreman [00:24:23]:
It’s easy to mess up. And that’s why I think it’s really important to think through what you’re doing, make sure you’re dotting your I’s, crossing your T’s, and make sure you get it right. All right. Well, that was the 44th episode of How Tax Works. Hope you learned something. I’ll be back in two weeks with the 45th episode, which I’m actually recording right after this. It’s about stock sales, taxes, asset sales, selling wholly owned subsidiaries, and elections under 338G, 338H10, and 336E. Now for some delightful music.
Mathew Foreman [00:24:51]:
Thanks for listening.