Don’t Accidentally Disqualify Your QSBS by “Resetting” It

Don’t Accidentally Disqualify Your QSBS by “Resetting” It

Startup founders and investors love Section 1202’s qualified small business stock (QSBS) exclusion because it allows holders to avoid tax on gain when they sell stock of a qualified C‑corporation. The recently enacted One Big Beautiful Bill Act (OBBBA) makes this benefit even more attractive for new investments by shortening the holding period, increasing the gain cap and broadening the size of qualifying companies. However, these changes have caused some holders of existing QSBS to wonder whether they can “refresh” or recapitalize their stock to take advantage of the new rules. The answer is generally no—and the consequences of getting it wrong can be severe.

What Changed Under the OBBBA

On July 4 2025 President Trump signed the OBBBA into law. The statute introduced three major changes to Section 1202, all of which apply only to stock issued after the act’s effective date:

• Shorter holding period – Under prior law, QSBS had to be held more than five years to exclude 100 % of the gain (subject to a cap). The OBBBA introduced a tiered schedule for post‑July 4 2025 stock: investors may exclude 50 % of gain when stock is held at least three years and less than four, 75 % of gain after four years and less than five, and 100 % after five years. Pre‑act stock must still be held for more than five years to claim any exclusion.
• Larger company eligibility – Before the law, QSBS benefits applied only when the issuing corporation’s aggregate gross assets did not exceed $50 million. The OBBBA increased the threshold to $75 million, indexed for inflation. This expansion allows more late‑stage startups to issue QSBS, but it is effective only for stock issued after July 4 2025.
• Higher exclusion cap – The per‑issuer gain cap increased from $10 million to $15 million, also indexed for inflation. The alternative cap of ten times the taxpayer’s basis continues to apply. The larger cap likewise applies only to new stock issued after July 4 2025.

Several articles emphasise that these benefits do not retroactively apply to stock issued before July 4 2025. For example, a Davis Wright Tremaine summary notes that QSBS issued on or before July 4 2025 “continue to be subject to the preexisting rules” and that the changes under the OBBBA apply only to post‑July 4 2025 stock.

The Original‑Issuance Requirement Still Rules

Section 1202 only applies to stock that is acquired directly from the corporation in exchange for cash, property (other than stock), or services. This is often called the original‑issuance requirement. A secondary purchase from another shareholder does not qualify because the buyer did not acquire the stock from the corporation. Likewise, “refreshing” your QSBS by exchanging it for newly issued shares can destroy QSBS status if the exchange does not fall into one of the statute’s narrow exceptions.

Exchanges, Reorganizations and “Refreshing” Stock

Conversions within the same corporation. When QSBS is converted into a different class of stock in the same corporation—such as exchanging common stock for preferred stock—the new shares are treated as QSBS and are considered acquired on the date the exchanged shares were originally issued. The holding period is tacked, meaning the clock does not restart.

Tax‑free reorganizations or Section 351 exchanges. Section 1202(h)(4) provides that if QSBS is exchanged for stock of another corporation in a Section 351 nonrecognition exchange or a tax‑free reorganization described in Section 368, the stock received will be treated as QSBS. The successor stock is deemed acquired on the date the surrendered QSBS was originally issued, so the holding period from the old shares carries over. The rule is subject to important limitations:

• Successor must be a qualified small business. If the acquiring corporation qualifies as a small business (i.e., its gross assets, including those of the target, are below the applicable threshold and it meets the active trade‑or‑business requirement), all the successor shares are QSBS and future appreciation is eligible for exclusion. If the successor corporation is not a qualified small business, only the built‑in gain on the exchanged QSBS is eligible; any post‑transaction appreciation will not be excludable.
• Control requirement for Section 351. In a Section 351 exchange, the successor corporation must own at least 80 % of the target corporation immediately after the transaction. If this control threshold is not met, the successor stock will not be treated as QSBS and the shareholder will not be entitled to the exclusion.

What happens if the exchange is not tax‑free? Absent a Section 351 or Section 368 reorganization, exchanging QSBS for other stock fails the original‑issuance requirement because stock received in exchange for other stock is not QSBS. In that case, the new shares will not qualify for Section 1202’s exclusion and the shareholder loses the QSBS benefit entirely.

You Can’t “Reset” the Clock

Even when an exchange qualifies under Section 351 or Section 368, the new stock inherits the holding period of the old QSBS. You cannot exchange five‑year‑old QSBS into new shares and magically restart the holding period under the OBBBA’s shorter three‑year rule. Similarly, you cannot switch to the higher $15 million cap by rolling your old QSBS into new shares. The OBBBA expressly states that the shorter holding periods and larger caps apply only to stock acquired after July 4 2025, and any tacked holding period rules must be taken into account. Attempting to engineer a new issuance or recapitalization to “refresh” your QSBS could therefore backfire, either by disqualifying the stock or by leaving you stuck with the old regime.

Takeaways for Founders and Investors

1. Understand the cutoff. QSBS acquired after July 4 2025 is subject to the OBBBA’s shorter holding periods, higher gain caps and expanded eligibility thresholds. Stock issued on or before July 4 2025 remains subject to the pre‑act five‑year holding period and $10 million gain cap.
2. Do not attempt to “refresh” QSBS without careful tax planning. The original‑issuance requirement means that exchanging QSBS for new shares generally disqualifies the stock unless the transaction fits within Section 351 or Section 368. Even when it does, the holding period carries over.
3. Beware of successor company qualifications. In tax‑free reorganizations, the successor corporation must itself be a qualified small business for the new stock to receive full QSBS treatment.
4. Seek professional advice. QSBS planning has become more attractive under the OBBBA, but it remains technical. Missteps in corporate restructurings, recapitalizations or estate planning can cause you to lose the QSBS exclusion. Work with experienced tax counsel to evaluate any proposed transactions.

The QSBS exclusion is a powerful tool for founders and investors, but its benefits hinge on careful adherence to the statute. The OBBBA expands those benefits for new investments, yet it does not provide a shortcut for existing stock. Before embarking on any restructuring, consult a knowledgeable tax advisor to ensure that your QSBS remains qualified and that you do not inadvertently give up a valuable exclusion.

Next: Does Washington’s Capital Gains Tax Apply to QSBS Gains?