QSBS Transfers and Conversions: Preserving QSBS Status Through Transactions

QSBS status can be preserved through certain transfers and conversions, allowing taxpayers to transfer QSBS to family members, heirs, or convert between classes of stock without losing QSBS benefits. Section 1202(h) and related provisions provide rules for transfers by gift, death, and corporate transactions.

This page explains how transfers and conversions affect QSBS status and what is required to preserve QSBS benefits.

Transfers by Gift

General Rule

Under Section 1202(h), transfers by gift preserve QSBS status. [IRC §1202(h)(2)(A)]

The donee (recipient) is treated as:

• Having acquired the stock in the same manner as the donor [IRC §1202(h)(1)(A)]
• Having held the stock during the continuous period it was held by the donor [IRC §1202(h)(1)(B)]

Key Benefit: The donee's holding period includes the donor's holding period, allowing the donee to satisfy holding period requirements even if the donee didn't hold the stock for the full period.

Example

Donor holds QSBS for 4 years, then gifts it to Donee. Donee holds for 1 more year, then sells. Donee is treated as having held the stock for 5 years total (4 years from donor + 1 year from donee), satisfying the 5-year holding period requirement.

Basis Considerations

For gift tax purposes, the donee's basis is generally the donor's basis (carryover basis) or fair market value if lower (for purposes of determining loss). However, for Section 1202 purposes, the donee is treated as having acquired the stock in the same manner as the donor.

Transfers at Death

General Rule

Under Section 1202(h), transfers at death preserve QSBS status. [IRC §1202(h)(2)(B)]

The beneficiary/heir is treated as:

• Having acquired the stock in the same manner as the decedent [IRC §1202(h)(1)(A)]
• Having held the stock during the continuous period it was held by the decedent [IRC §1202(h)(1)(B)]

Key Benefit: Like gifts, the beneficiary's holding period includes the decedent's holding period.

Basis Step-Up Does Not Affect QSBS Status

Under Section 1014, property acquired from a decedent generally receives a step-up (or step-down) in basis to fair market value at death. However, for Section 1202 purposes, the beneficiary is treated as having acquired the stock in the same manner as the decedent, preserving QSBS status.

Important: The step-up in basis under Section 1014 applies for general tax purposes, but Section 1202(h) preserves QSBS status.

Estate Planning Benefits

Transfers at death allow QSBS to pass to heirs while preserving:

• QSBS qualification
• Holding period (including decedent's period)
• Ability to claim Section 1202 exclusion

Partnership Distributions

General Rule

Section 1202(h) provides that distributions from partnerships to partners preserve QSBS status if requirements similar to Section 1202(g) are met at the time of transfer (without regard to the 5-year holding period requirement). [IRC §1202(h)(2)(C)]

Regulation 1.1045-1(e) provides detailed rules for partnership distributions of QSBS.

Requirements

For a partnership distribution to preserve QSBS status:

• All eligibility requirements with respect to QSBS as defined in Section 1202(c) must be met by the distributing partnership [Reg. 1.1045-1(e)(2)]
• The partner must have held an interest in the partnership when the partnership acquired the QSBS

Distribution Limitations

The amount of gain that can be deferred on subsequent sale of distributed QSBS is subject to the "distribution nonrecognition limitation," which is based on the partner's capital interest in the partnership. [Reg. 1.1045-1(e)(3)]

Section 351 Exchanges

General Rule

Section 1202(h)(4) provides that in a Section 351 transaction, if QSBS is exchanged for other stock, the new stock is treated as QSBS 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)]

Limitation

The exclusion applies only to the extent of the gain that would have been recognized at the time of the transfer if Section 351 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)]

Example: If QSBS with $1 million basis and $10 million value is exchanged in a Section 351 transaction for stock worth $10 million, the exclusion applies to the $9 million gain that would have been recognized. If the new corporation is also a qualified small business, the full exclusion applies to future gain.

Successive Applications

Stock treated as QSBS under Section 1202(h)(4) is so treated for subsequent transactions or reorganizations, with the limitation applied as of the time of the first transfer. [IRC §1202(h)(4)(C)]

Corporate Reorganizations

General Rule

Section 1202(h)(4) provides similar rules for reorganizations described in Section 368. [IRC §1202(h)(4)(A)]

If QSBS is exchanged for other stock in a reorganization, the new stock is treated as QSBS acquired on the date the exchanged stock was acquired.

Limitation

The same limitation applies as for Section 351 exchanges—the exclusion applies only to the extent of gain that would have been recognized, unless the new corporation is a qualified small business. [IRC §1202(h)(4)(B)]

Conversion of Stock

General Rule

Section 1202(f) provides that if stock is acquired solely through the conversion of other stock in the same corporation which is QSBS:

• The converted stock is treated as QSBS [IRC §1202(f)(1)]
• The converted stock is treated as having been held during the period the original stock was held [IRC §1202(f)(2)]

Example: Preferred stock that is QSBS converts to common stock. The common stock is treated as QSBS, and the holding period includes the period the preferred was held.

Common Conversions

• Preferred stock converting to common stock
• Convertible debt converting to stock
• Stock splits and stock dividends (if structured as conversions)

Transfers That Do NOT Preserve QSBS Status

Sales and Exchanges

Sales and exchanges (other than those specifically covered by Section 1202(h)) do not preserve QSBS status. The purchaser acquires new stock that must independently qualify as QSBS.

Transfers to Non-Qualified Recipients

Transfers that don't meet the requirements of Section 1202(h) do not preserve QSBS status.

Planning Considerations

Estate Planning

• QSBS can be gifted to family members, preserving QSBS status and holding periods
• QSBS passes to heirs at death, preserving QSBS status
• Consider gifting QSBS to utilize annual gift tax exclusions and transfer wealth

Corporate Transactions

• Section 351 exchanges can preserve QSBS status if structured properly
• Reorganizations can preserve QSBS status subject to limitations
• Stock conversions preserve QSBS status

Partnership Planning

• Distributions from partnerships can preserve QSBS status
• Capital interest limitations may apply to distributed QSBS
• Consider distribution timing and structure

Key Takeaways

1. Gifts preserve QSBS status: Donees are treated as having held the stock during the donor's holding period

2. Death transfers preserve QSBS status: Beneficiaries are treated as having held the stock during the decedent's holding period

3. Partnership distributions can preserve QSBS status: Subject to eligibility requirements and capital interest limitations

4. Section 351 exchanges can preserve QSBS status: If control test is met, subject to gain limitation

5. Reorganizations can preserve QSBS status: Similar to Section 351 exchanges

6. Stock conversions preserve QSBS status: Converted stock is treated as QSBS with tacked holding period

7. Sales do not preserve QSBS status: Purchasers must independently qualify

Sources and Citations

• IRC Section 1202(h): Certain tax-free and other transfers
• IRC Section 1202(f): Stock acquired on conversion of other stock
• IRC Section 1202(h)(4): Section 351 exchanges and reorganizations
• Reg. 1.1045-1(e): Partnership distributions of QSB stock
• IRC Section 1014: Basis of property acquired from a decedent

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Transfer and conversion rules are complex and fact-specific. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding transfers, conversions, and estate planning involving QSBS.