QSBS Common Issues and Pitfalls: Mistakes to Avoid with Qualified Small Business Stock

Qualified Small Business Stock (QSBS) offers significant tax benefits, but the rules are complex and strict. Many taxpayers make mistakes that result in loss of QSBS benefits, audit issues, or compliance problems. This page identifies common pitfalls and mistakes, explaining how to avoid them.

Acquisition Mistakes

Mistake 1: Buying Stock on the Secondary Market

The Problem: QSBS must be acquired at original issue directly from the corporation (or through an underwriter). Stock purchased on the secondary market does not qualify as QSBS, even if the issuing corporation otherwise meets all QSBS requirements. [IRC §1202(c)(1)(B)]

How to Avoid: Only acquire stock directly from the issuing corporation or through an underwriter in the original issuance. Do not purchase QSBS on stock exchanges or secondary markets.

Mistake 2: Not Verifying Original Issue

The Problem: Assuming stock is QSBS without verifying it was acquired at original issue.

How to Avoid:

• Obtain documentation showing the stock was issued directly by the corporation
• Verify the acquisition method before relying on QSBS benefits
• Maintain records of stock purchase agreements and corporate records

Holding Period Mistakes

Mistake 3: Not Meeting the Minimum Holding Period

The Problem: Selling QSBS before the required holding period:

• Stock acquired on or before July 4, 2025: Must be held for more than 5 years
• Stock acquired after July 4, 2025: Must be held for at least 3 years (with percentage increasing with longer holding periods)

How to Avoid:

• Track acquisition dates carefully
• Do not sell until the required holding period is met
• Understand that "more than 5 years" means at least 5 years and 1 day for pre-applicable date stock

Mistake 4: Miscalculating Holding Period

The Problem: Incorrectly calculating the holding period, especially for:

• Stock received through transfers (gifts, inheritances, reorganizations)
• Stock held through partnerships
• Stock acquired through conversions

How to Avoid:

• Understand Section 1223 holding period rules
• Apply Section 1202(h) rules for transfers
• Consult tax professionals for complex situations

Corporate Qualification Mistakes

Mistake 5: Not Verifying C Corporation Status

The Problem: QSBS must be stock in a C corporation. S corporations, partnerships, and LLCs do not qualify. [IRC §1202(d)(1)]

How to Avoid:

• Verify the corporation's tax status
• Ensure the corporation remains a C corporation throughout the holding period
• Be aware that conversion to S corporation status would disqualify the stock

Mistake 6: Ignoring the Asset Test

The Problem: The corporation must meet the $75 million aggregate gross asset test (increased from $50 million for stock issued after July 4, 2025) at issuance and historically. [IRC §1202(d)(1)]

How to Avoid:

• Verify aggregate gross assets at the time of issuance
• Consider controlled group aggregation rules
• Obtain corporate representations regarding asset levels

Mistake 7: Overlooking Active Business Requirements

The Problem: The corporation must use at least 80% of its assets in the active conduct of a qualified trade or business, and this must be maintained throughout the holding period. [IRC §1202(e)(1)(A)]

How to Avoid:

• Verify the corporation's business activities qualify
• Understand excluded businesses (professional services, financial services, etc.)
• Monitor that the corporation maintains compliance throughout the holding period

Mistake 8: Investing in Excluded Businesses

The Problem: Certain businesses are ineligible, including:

• Professional services (law, accounting, consulting, health, etc.)
• Financial services (banking, insurance, investing)
• Farming
• Natural resource extraction
• Hospitality (hotels, restaurants)

How to Avoid:

• Verify the corporation's business is not in an excluded category
• Understand that hybrid businesses may have qualification issues
• Consult tax professionals for borderline cases

Redemption Mistakes

Mistake 9: Triggering Disqualifying Redemptions

The Problem: Stock is disqualified if:

• The corporation purchases stock from the taxpayer or related persons during a 4-year period beginning 2 years before issuance (subject to de minimis exceptions) [IRC §1202(c)(3)(A)]
• The corporation makes significant redemptions (more than 5% of aggregate stock value) during a 2-year period beginning 1 year before issuance [IRC §1202(c)(3)(B)]

How to Avoid:

• Understand redemption restrictions before investing
• Verify no disqualifying redemptions have occurred
• Review corporate redemption history

For details, see [Reg. 1.1202-2].

Per-Issuer Limit Mistakes

Mistake 10: Exceeding Per-Issuer Limits

The Problem: The exclusion is limited per issuer to:

• $10 million (for stock acquired on or before July 4, 2025) or $15 million (for stock acquired after July 4, 2025), or
• 10 times adjusted basis (whichever is greater) [IRC §1202(b)(4)]

How to Avoid:

• Track gains from each issuer separately
• Understand that the limit applies per issuer, not per investment
• Plan sales to maximize benefits across multiple issuers

Mistake 11: Not Understanding the "10 Times Basis" Alternative

The Problem: The per-issuer limit is the greater of the dollar amount or 10 times adjusted basis. For high-basis stock, 10 times basis may provide a higher limit.

How to Avoid:

• Calculate both limits
• Use the higher limit
• Remember: Basis is determined without regard to additions after original issuance for this calculation

Partnership Mistakes

Mistake 12: Assuming Partnership QSBS Always Qualifies

The Problem: While Section 1202(g) allows pass-through treatment, partners must:

• Hold interests continuously from QSBS acquisition through disposition
• Meet other partnership-specific requirements
• Understand capital interest limitations for Section 1045 rollovers

How to Avoid:

• Understand Section 1202(g) requirements
• Document partnership interests held continuously
• Be aware of capital interest limitations for rollovers
• See QSBS and Partnerships for details

Mistake 13: Ignoring Capital Interest Requirements for Rollovers

The Problem: Regulation 1.1045-1(d) limits Section 1045 rollover benefits based on partners' smallest percentage interest in partnership capital. Partners with only profits interests (carried interest) may have zero or minimal rollover benefits.

How to Avoid:

• Understand the capital interest limitation
• Consider structuring to include capital interests if rollover benefits are desired
• Document capital interest percentages

Documentation Mistakes

Mistake 14: Inadequate Documentation

The Problem: Failing to maintain documentation to substantiate QSBS status, which can cause problems in audits.

How to Avoid: Maintain records of:

• Stock purchase documents (showing original issue)
• Corporate records (C corporation status, asset levels, business activities)
• Holding period documentation
• Corporate representations regarding QSBS qualification
• Partnership agreements and interest documentation (if applicable)

Mistake 15: Not Documenting Corporate Qualification

The Problem: Assuming a corporation qualifies without proper documentation.

How to Avoid:

• Obtain corporate representations regarding QSBS qualification
• Review corporate financial statements
• Verify business activities qualify
• Document asset levels at issuance

Reporting Mistakes

Mistake 16: Incorrect Tax Return Reporting

The Problem: Failing to properly report QSBS exclusions on tax returns.

How to Avoid:

• Report QSBS sales on Form 8949 and Schedule D
• Properly calculate and report excluded amounts
• Follow IRS forms and instructions
• See QSBS Reporting Requirements for details

Mistake 17: Not Reporting at All

The Problem: Some taxpayers incorrectly believe excluded gains don't need to be reported.

How to Avoid:

• Report all sales, even if gain is excluded
• Show excluded amounts separately
• Follow IRS reporting requirements

State Tax Mistakes

Mistake 18: Assuming State Conformity

The Problem: Section 1202 is a federal provision. States may not conform, meaning you may owe state tax on gains excluded for federal purposes.

How to Avoid:

• Check your state's tax laws
• Do not assume state conformity
• Plan for potential state tax liability
• Consult state tax professionals

Planning Mistakes

Mistake 19: Not Planning for Holding Period

The Problem: Selling before the required holding period or not planning sales to maximize benefits.

How to Avoid:

• Plan investments with holding period requirements in mind
• Understand exclusion percentages for different holding periods
• Consider timing of sales to maximize benefits

Mistake 20: Not Coordinating Multiple QSBS Holdings

The Problem: Not maximizing benefits across multiple QSBS issuers.

How to Avoid:

• Understand that limits apply per issuer
• Plan sales to maximize exclusions across multiple issuers
• Coordinate timing of sales from different issuers

Audit Risks

Common Audit Issues

The IRS may audit QSBS claims focusing on:

• Whether stock was acquired at original issue
• Whether the corporation qualifies as a qualified small business
• Whether holding period requirements are met
• Whether per-issuer limits are correctly applied
• Whether active business requirements were met throughout the holding period

Reducing Audit Risk

• Maintain comprehensive documentation
• Obtain professional tax advice
• Use corporate representations where appropriate
• Follow all reporting requirements
• Understand and comply with all rules

Key Takeaways

1. Original issue is required: Cannot buy on secondary market

2. Holding period is strict: Must meet minimum requirements (3-5 years depending on acquisition date)

3. Corporate qualification matters: Must verify C corporation status, asset test, and active business requirements

4. Documentation is critical: Maintain records to substantiate QSBS status

5. Per-issuer limits apply: Understand and track limits per issuer

6. State taxes may apply: Section 1202 is federal only

7. Partnership rules are complex: Understand partnership-specific requirements

8. Professional advice is valuable: QSBS rules are complex; consult tax professionals

Sources and Citations

• IRC Section 1202: Partial exclusion for gain from certain small business stock
• IRC Section 1202(c)(1)(B): Original issue requirement
• IRC Section 1202(c)(3): Redemption restrictions
• IRC Section 1202(b)(4): Per-issuer limits
• IRC Section 1202(e): Active business requirements
• Reg. 1.1202-2: Redemption rules
• Reg. 1.1045-1(d): Partnership capital interest limitation

Verification Date: January 2025

Note: This page identifies common mistakes based on the QSBS rules as of January 2025. Tax law is complex and changes frequently. This information should not be construed as legal or tax advice. The best way to avoid mistakes is to consult with qualified tax professionals familiar with QSBS rules. Each situation is unique, and professional advice tailored to your circumstances is essential.