Episode Summary: Common Mistakes and Misconceptions Regarding Qualified Small Business Stock (QSBS) Under Section 1202

Podcast: How Tax Works
Host: Matthew Foreman, Co-Chair, Taxation Practice Group, Falcon Rappaport & Berkman LLP
Date: January 20, 2026
Duration: Approx. 48 minutes

Overview

In this episode, Matt Foreman demystifies Qualified Small Business Stock (QSBS) under Section 1202 of the IRS Code, focusing on common mistakes and misconceptions made by taxpayers and advisors. He outlines the practical requirements for QSBS qualification, walks through significant pitfalls, and offers guidance using real-world scenarios to highlight both frequent errors and subtle nuances that can lead to costly tax consequences. This episode aims to equip accountants, lawyers, business owners, and interested listeners with critical knowledge to navigate the intricacies of QSBS effectively.

“QSBS is a really important one because it leads to a question of: why do we care? And the reason that we care is you have a possible tax rate of 0%. In theory, the best possible tax rate.” — Matt Foreman [03:05]

Key Discussion Points & Insights

1. QSBS Basics & Key Requirements

[02:10–14:30]

• Main criteria:
  • Non-corporate taxpayer may exclude 50–100% of gain realized on sale of QSBS.
  • Stock must be acquired after August 10, 1993, and held for five years (recent changes include three- and four-year benchmarks for certain periods post-2025).
  • Exclusion* applies to greater of $10M–$15M or 10x the taxpayer’s basis.
  • Basis is not always tax basis; could refer to FMV or book value at time of contribution—often misunderstood.
  • Issuer must be a domestic C-Corp, and aggregate gross assets cannot exceed $50M ($75M for stock issued after July 3, 2025).
  • Active business test: 80% or more of assets must be used in the active conduct of a qualified business; most service, finance, and some real estate businesses are not eligible.
  • Limitations on cash and securities: too much cash or non-operating securities can ruin QSBS qualification.

“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... Most people get $10M or $15M, but there’s a concept called stacking—it can really increase the exclusion amount.” — Matt Foreman [06:05]

2. Timeline & Exclusion Evolution

[07:25–12:35]

• Exclusion percentage depends on date of acquisition (See chart below):
  • 08/11/1993–02/17/2009: 50% exclusion
  • 02/18/2009–09/27/2010: 75% exclusion
  • After 09/27/2010: 100% exclusion
  • After 07/03/2025: 3 yrs (50%), 4 yrs (75%), 5 yrs (100%)

3. Common QSBS Mistakes and Misconceptions: Key Pitfalls

[17:00–46:12]

Matt identifies seven primary traps:

a) Contribution to Partnership

[18:00–23:30]

• Mistake: Believing that QSBS status survives a contribution to a partnership.
  • Once contributed, in the hands of the partnership, the stock is NOT QSBS.
  • Investment in QSBS through partnerships is possible, but transferring stock AFTER acquisition voids QSBS treatment for the recipient.
  • Treasury regs say so, but the statutory deference isn’t settled—still, don’t risk it.

“Don’t put [QSBS] into a partnership... You could be arguing pretty uphill in an audit. This is a large amount of money you could be saving in tax.” — Matt Foreman [20:05]

b) Use of Grantor Trusts (Including Intentionally Defective Grantor Trusts, IDGTs)

[23:30–28:00]

• Mistake: Thinking separate stacking is possible via grantor trusts.
  • Grantor trust is disregarded for income tax—no “new” taxpayer, no stacking.
  • Non-grantor trust may create exclusion, but errors are frequent in setup.
  • Death typically renders stacking pointless due to step-up in basis.
• Named cases to refer: Dobson, Eisner v. Macomber; Rev. Rul. 55-77.

"It’s kind of the worst of both worlds, because you’re not stacking... no transfer actually occurred for income tax purposes.” — Matt Foreman [25:10]

c) Tax-Free Reorganizations (Mergers & 351/368 Exchanges)

[28:00–34:10]

• Mistake: Assuming exchanging QSBS for public company stock in a tax-free merger triggers exclusion.
  • Exclusion is not realized until the public stock is ultimately sold; QSBS attributes “carry over.”
  • Pitfall if company asset test ($50M) is exceeded post-merger: Exclusion may get capped or lost.
  • “Permanent” status of section 1202 is suspect; if repealed before final sale, you could lose the benefit.

"If you hold the public company stock for another three, four years... then you can sell that public company stock and get QSBS." — Matt Foreman [31:28]

d) Original Issuance and Redemption

[34:10–39:10]

• Mistake: Believing stock bought from another shareholder or recently redeemed is QSBS.
  • Must acquire directly from issuing corporation.
  • Congress anticipated “refreshing” QSBS via redemption and blocked it with related/sizable redemption rules (within specific timeframes and ownership tests).
  • Watch fair market value thresholds: exceeding 5% may disqualify redemptions from QSBS status.

e) State Conformity: New Jersey, California, Massachusetts, etc.

[39:10–41:25]

• Mistake: Assuming state tax follows federal QSBS treatment.
  • Many states, e.g., California, do not conform—QSBS exclusion may not apply at the state level.
  • Timing or attempting to move state for a sale rarely works ex-post.

"Even though you might federally have no tax, some states might be taxable. So just watch out for that." — Matt Foreman [40:19]

f) Stock Acquired in Pre-1997 or Transitional Periods

[41:26–44:28]

• Mistake: Misunderstanding the capital gains rates attached to partial exclusions in earlier years.
  • The excluded portion is taxed at special rates (typically 28%), not regular capital gains rates.
  • Example: If you acquired QSBS in 1997, your net effective rate is not half 23.8%, but half of the higher rate (approx. 15.9%).

"It's not the 23.8% that you think it is ... it kicks the rate up on the non-excluded portion to the highest capital gains rate that exists." — Matt Foreman [42:25]

g) Three-Year, Four-Year, Five-Year Rule Post-2025

[44:28–46:12]

• Mistake: Misapplying the new three-year/four-year/five-year holding periods, leading to overstatement of benefits.
  • Especially egregious for those who barely cross the threshold; misunderstanding may lead, after a three-year hold, to a 50% exclusion at a higher rate rather than the full exclusion.

Notable Quotes & Memorable Moments

• “Don’t read into the code section what’s not there. Don’t read into regs what’s not there. Make sure to fully understand what the code says and what it does not say.” — Matt Foreman [17:00]
• “The premise of the partnership... you can invest through a partnership, that’s not a problem. But if you contribute stock, that’s not qualifying stock in the hands of the partnership.” — [19:10]
• “If you qualify for QSBS, you qualify under 199A. Sometimes, especially for profitable businesses, chasing QSBS isn’t always the way to go.” — [46:00]

Timestamps for Key Segments

| Topic | Timestamp | |-----------------------------------------------------|--------------| | Introduction & Episode Focus | 00:00–03:00 | | General QSBS Requirements & Technical Caveats | 03:00–14:30 | | Exclusion Timeline (Percentages/Years) | 07:25–12:35 | | Common Mistakes Overview | 17:00–18:00 | | Contribution to Partnership | 18:00–23:30 | | Grantor Trusts and Stacking | 23:30–28:00 | | Tax-Free Mergers / Reorgs | 28:00–34:10 | | Original Issuance & Redemption Problems | 34:10–39:10 | | State QSBS Nonconformity | 39:10–41:25 | | Pre-1997/Transitional Period Rate Pitfalls | 41:26–44:28 | | Three/Four/Five Year Rule Clarifications | 44:28–46:12 | | Why Chasing QSBS Isn’t Always Best/Farewell | 46:12–48:00 |

Final Thoughts

• Double-check all structuring for QSBS qualification.
• Be wary of assumptions about trusts, mergers, and state law conformity.
• New holding period rules post-2025 will introduce more complexity.
• Consult tax professionals; these errors are costly and sometimes irreversible.

“It’s a risk. QSBS is a significant risk. It’s easy to mess up. Make sure you’re dotting your I’s, crossing your T’s, and make sure you get it right.” — Matt Foreman [46:52]

*For follow-up or clarification, listeners are encouraged to email Matt or seek guidance from their own advisors.