What is the holding period requirement?

Stock has to be held for more than 5 years in order to qualify as “eligible gains” for QSBS purposes. (as per Section 1202(b)(2)).

When Does My Timeline Start for QSBS?

The required holding period for section 1202 QSBS starts the day the stock is acquired/issued.  If stock was acquired through other securities such as convertible debt or stock options, the holding period for QSBS generally starts on the date the securities are converted to the stock.

The following list shows the holding period timelines for various security types. 

What Happens if I Sell My QSBS Stock in under 5 years?

Gains on stock sold in under five years would not be considered “eligible” for QSBS tax treatment, and the capital gains will be taxed at the individuals capital gains rate.  However, an alternative is to roll the sale proceeds into another company qualifying for QSBS, electing section 1045

What if the corporation that issued the QSBS stock is Acquired or Merged into another Company before Five Years?

In a merger, the QSBS qualification and holding period will be maintained if the merger is considered a tax-free stock transfer as (1) a section 351 stock exchange or (2) a section 368 reorganization.

The entity or individual receiving QSBS in a tax-free transfer will keep the prior holders’ holding period. For example, if an investor purchased QSBS in ABC Corporation 3 years ago then decided to gift the stock to his grandchild, his holding period passes to his grandchild. Therefore, if the grandchild holds the QSBS stock for another 2 years, they will receive the section 1202 tax exclusion.

Under Section 1202(h)(4) the holder of QSBS can exchange their stock for other QSBS or non-QSBS stock when electing Section 351(a). Section 351(a) allows the holder to conduct a tax-free transaction, exchanging either corporate stock or property.

Immediately after the exchange, the company issuing new stock in exchange for the QSBS has to have control of the QSBS corporation in terms of Section 368. Under Section 368 control means at least 80% of the voting power and at least 80% of the number of shares of other issued stock.

If the QSBS is exchanged for newly issued QSBS the stock will (i) maintain its holding period, (ii) defer any existing gains, and (iii) accumulate more Section 1202 QSBS tax gains to be included in the exclusion when the second QSBS is sold. Under Section 351(a) the QSBS can be exchanged for non-QSBS as stock and still maintain the first two caveats above, but it will not accumulate any new Section 1202 QSBS gains. When the non-QSBS is sold the built-in QSBS gain will be excluded but any new gains will be taxed at the taxpayer’s corporate tax rate.

If a company was acquired in a tax-free stock transaction the company acquiring the QSBS company would issue new stock in exchange for controlling ownership of the QSBS company. When the newly issued stock in the acquiring company qualifies as QSBS then nothing would change in terms of tax exclusion or holding period for the QSBS holder. The only caveat when the newly issued stock of the acquiring company is non-QSBS is that any gains after the issuance of the stock would not qualify for the QSBS tax exclusion; therefore, the only gain on allowed on the sale of the new stock would be the built-in gain from the original QSBS.

An example of a Section 351 tax-free transaction

In 2012, ABC Corp raised $20 million in funding with an investor leading the round with a $5 million investment. The newly issued stock qualified as QSBS. Three years later the ABC Corp was acquired under a Section 351(a) tax-free stock exchange transaction. The acquirer exchanged newly issued non-QSBS for 100% of the stock in ABC Corp with a value of 2x the value the investors paid for their stock in ABC Corp. Therefore the lead investor received $10 million worth of non-QSBS from the acquirer. After the lead investor held onto the stock for two more years to meet the five year holding period, he sold the stock for $15 million. Since the stock received was non-QSBS, the total QSBS tax exclusion would equal the built-in gain at the time of the exchange of $5 million ($5 million x 2) and the taxable gains would be the $5 million earned over the two years post Section 351 transaction.

Although the investor still has to pay taxes on the $5 million he saved $1.19 million ($5 million x 23.8%) in taxes from the Section 351 transaction.

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

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