QSBS Stock Acquisition Rules: Original Issue and Redemption Restrictions

One of the most critical requirements for Qualified Small Business Stock (QSBS) is that the stock must be acquired at original issue. This requirement, along with restrictions on corporate redemptions, is strictly enforced and is one of the most common reasons QSBS benefits are lost.

This page explains the original issue requirement, redemption restrictions, and how stock must be acquired to qualify for QSBS benefits.

Original Issue Requirement

Basic Rule

QSBS must be acquired by the taxpayer at its original issue (directly or through an underwriter) in exchange for:

• Money or other property (not including stock), or
• As compensation for services provided to the corporation (other than services performed as an underwriter) [IRC §1202(c)(1)(B)]

Critical Point: Stock purchased on the secondary market, even if the issuing corporation otherwise qualifies as a qualified small business, does not qualify as QSBS.

What Constitutes Original Issue?

Original issue means:

• Stock issued directly by the corporation to the taxpayer
• Stock issued through an underwriter in the original issuance
• Stock received as compensation for services (other than underwriting services)

Does NOT include:

• Stock purchased from another shareholder
• Stock purchased on stock exchanges
• Stock acquired in secondary market transactions
• Stock received in transfers that don't preserve QSBS status under Section 1202(h)

Through an Underwriter

Stock acquired "through an underwriter" in the original issuance qualifies. [IRC §1202(c)(1)(B)]

An underwriter is a person who purchases stock from the issuer with a view to distribution, or who participates in the distribution of stock.

Redemption Restrictions

Regulation 1.1202-2 provides detailed rules on how redemptions can disqualify QSBS.

Redemptions from Taxpayer or Related Persons

Stock acquired by a taxpayer is not qualified small business stock if, at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the issuing corporation purchases (directly or indirectly) more than a de minimis amount of its stock from:

• The taxpayer, or
• A person related (within the meaning of Section 267(b) or 707(b)) to the taxpayer [IRC §1202(c)(3)(A)]

De Minimis Exception

Stock acquired from the taxpayer or related person exceeds a de minimis amount only if:

• The aggregate amount paid for the stock exceeds $10,000, and
• More than 2% of the stock held by the taxpayer and related persons is acquired [Reg. 1.1202-2(a)(2)]

Significant Redemptions

Stock issued by a corporation is not qualified small business stock if, during the 2-year period beginning on the date 1 year before the issuance of the stock, the corporation made one or more purchases of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5% of the aggregate value of all of its stock as of the beginning of such 2-year period. [IRC §1202(c)(3)(B)]

De Minimis Exception

For significant redemptions, stock exceeds a de minimis amount only if:

• The aggregate amount paid for the stock exceeds $10,000, and
• More than 2% of all outstanding stock is purchased [Reg. 1.1202-2(b)(2)]

Transactions Treated as Redemptions

If any transaction is treated under Section 304(a) as a distribution in redemption of stock, the corporation is treated as purchasing an amount of its stock equal to the amount treated as such a distribution. [IRC §1202(c)(3)(C)]

This prevents corporations from structuring transactions to avoid redemption rules.

Exceptions to Redemption Rules

Regulation 1.1202-2 provides exceptions for certain types of redemptions:

Transfers by Shareholders to Employees

A transfer of stock by a shareholder to an employee or independent contractor (or beneficiary) is not treated as a purchase by the issuing corporation, even if the stock is treated as having first been transferred to the corporation under Section 1.83-6(d)(1). [Reg. 1.1202-2(c)]

Termination of Services

Redemptions are disregarded if the stock was acquired by the seller in connection with the performance of services as an employee or director and the stock is purchased incident to the seller's retirement or other bona fide termination of such services. [Reg. 1.1202-2(d)(1)]

Death

Redemptions are disregarded if:

• Prior to death, the stock (or option) was held by the decedent or decedent's spouse (or both), by the decedent and joint tenant, or by a trust revocable by the decedent or decedent's spouse
• The stock is purchased from the decedent's estate, beneficiary, heir, surviving joint tenant, or surviving spouse, or from a trust established by the decedent or decedent's spouse
• The stock is purchased within 3 years and 9 months from the date of death [Reg. 1.1202-2(d)(2)]

Disability or Mental Incompetency

Redemptions are disregarded if the stock is purchased incident to the disability or mental incompetency of the selling shareholder. [Reg. 1.1202-2(d)(3)]

Divorce

Redemptions are disregarded if the stock is purchased incident to the divorce (within the meaning of Section 1041(c)) of the selling shareholder. [Reg. 1.1202-2(d)(4)]

Stock Acquired for Services

Stock acquired as compensation for services provided to the corporation (other than underwriting services) qualifies as QSBS if acquired at original issue. [IRC §1202(c)(1)(B)(ii)]

Key Points:

• Stock received as compensation qualifies
• The stock must still be acquired at original issue
• Underwriting services are excluded

Stock Acquired for Property

Stock acquired in exchange for money or other property (not including stock) qualifies as QSBS if acquired at original issue. [IRC §1202(c)(1)(B)(i)]

Key Points:

• Cash purchases qualify
• Property exchanges qualify
• Stock-for-stock exchanges do not qualify (unless structured as original issue)

Section 351 Exchanges and Reorganizations

Section 1202(h)(4) provides special rules for stock acquired in Section 351 exchanges and reorganizations.

Section 351 Exchanges

If qualified small business stock is exchanged for other stock in a Section 351 transaction, the new stock is treated as qualified small business stock acquired on the date the exchanged stock was acquired, if:

• Immediately after the transaction, the corporation issuing the stock owns directly or indirectly stock representing control (within the meaning of Section 368(c)) of the corporation whose stock was exchanged [IRC §1202(h)(4)(D)]

Reorganizations

Similar rules apply to reorganizations described in Section 368. [IRC §1202(h)(4)(A)]

Limitations

The exclusion applies only to the extent of the gain that would have been recognized at the time of the transfer if Section 351 or 368 had not applied, unless the new stock is issued by a corporation that is a qualified small business at the time of the transfer. [IRC §1202(h)(4)(B)]

Transfers That Preserve QSBS Status

Section 1202(h) provides that certain transfers preserve QSBS status:

• Gifts: Transfers by gift preserve QSBS status [IRC §1202(h)(2)(A)]
• Death: Transfers at death preserve QSBS status [IRC §1202(h)(2)(B)]
• Partnership distributions: Distributions from partnerships to partners preserve QSBS status (subject to requirements similar to Section 1202(g)) [IRC §1202(h)(2)(C)]

In these cases, the transferee is treated as having acquired the stock in the same manner as the transferor and having held it during the continuous period it was held by the transferor. [IRC §1202(h)(1)]

Key Takeaways

1. Original issue is required: Stock must be acquired directly from the corporation or through an underwriter at original issuance

2. Secondary market purchases don't qualify: Stock bought from other shareholders or on exchanges does not qualify

3. Redemption restrictions are strict: Corporate redemptions can disqualify stock, subject to de minimis and other exceptions

4. Exceptions exist: Certain redemptions (death, disability, divorce, termination of services) are disregarded

5. Services qualify: Stock received as compensation for services qualifies if acquired at original issue

6. Transfers preserve status: Gifts, death transfers, and certain partnership distributions preserve QSBS status

7. Section 351/reorganizations: Special rules apply to preserve QSBS status in certain 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.