Qualified small business stock (“QSBS”) is a special type of stock that can result in 0% federal tax on the gain (up to a cap) from a sale if held more than 5 years. That is the good news.
The bad news is that a company can accidentally disqualify otherwise eligible stock by repurchasing too much of its own stock around the time the stock is issued.
This is known as the significant redemption rule.
The rule is particularly dangerous because it does not merely affect the shares that are repurchased. A redemption can create a blackout period during which newly issued stock does not qualify as QSBS.
Why Does Section 1202 Care About Redemptions?
To qualify as QSBS, stock generally must be acquired at original issuance from a domestic C corporation in exchange for money, property other than stock, or services.
Congress did not want companies manufacturing original-issue stock by redeeming shares from one stockholder and issuing replacement shares to another. Section 1202 therefore contains two overlapping redemption tests:
- The company test, which looks at redemptions from all stockholders; and
- The individual test, which looks at redemptions from the particular taxpayer receiving the stock and certain related persons.
The Company Test: The Two-Year Blackout
The company test examines the period beginning one year before and ending one year after the issuance of the stock being tested.
For example, if a company issues stock to Jenna on July 1, 2026, the relevant period generally runs from July 1, 2025, through June 30, 2027.
Jenna’s stock can be disqualified if, during that period, the company:
- Purchases more than a de minimis amount of its own stock; and
- The redeemed stock has an aggregate value exceeding 5% of the value of all the company’s outstanding stock as of the beginning of the two-year period.
This is a company-wide test. The repurchased stock does not need to have been held by Jenna. A repurchase from a founder, former employee, investor, or other stockholder can potentially disqualify stock issued to Jenna.
The practical result is a rolling blackout period. Each stock issuance must be tested by looking backward one year and forward one year.
The De Minimis Exception
A redemption is not more than de minimis for purposes of the company test unless both of the following are true:
- The aggregate amount paid for the redeemed stock exceeds $10,000; and
- The company purchases more than 2% of its outstanding stock.
Thus, a $9,000 repurchase is generally disregarded even if it represents more than 2% of the company. Similarly, a $100,000 repurchase is generally disregarded if it represents no more than 2% of the company.
Both thresholds must be exceeded.
A common mistake is to apply the 2% test based solely on the number of shares repurchased. The regulations instead compare the value of the stock repurchased with the value of all stock outstanding immediately before the purchase.
That distinction matters when a company has multiple classes of stock with different values.
How Multiple Repurchases Are Counted
Breaking a repurchase into several smaller transactions does not necessarily solve the problem.
When a company makes multiple purchases during the relevant period, the percentages determined for each separate purchase are added together for purposes of the 2% de minimis test.
Example: A company repurchases stock worth 1.2% of its outstanding equity in March and stock worth another 1.1% in September. The two repurchases may be aggregated, resulting in a 2.3% redemption.
The 5% test is also based on the aggregate value of the stock purchased during the relevant period. That amount is compared with the value of all the company’s stock at the beginning of the two-year testing period.
This creates a potentially odd result when a company’s value changes substantially. The redeemed shares are valued when each repurchase occurs, while the denominator for the 5% test is generally determined as of the beginning of the two-year period.
Example: A Founder Repurchase
Assume Startup, Inc. was worth $10 million on January 1, 2026.
Startup issues stock to a new executive on January 1, 2027. The company-test period therefore begins on January 1, 2026, and ends on December 31, 2027.
During 2026 and 2027, Startup repurchases founder stock for $600,000.
Assume the repurchased stock also represents more than 2% of Startup’s outstanding equity and of course the amount paid exceeds $10,000.
Because $600,000 exceeds 5% of the company’s $10 million value at the beginning of the testing period, the repurchase disqualifies the executive’s January 1, 2027 stock from QSBS treatment.
It does not matter that the executive had nothing to do with the founder’s liquidity transaction.
The Individual Test: The Four-Year Blackout
The individual test is broader in time but narrower in who it covers.
It examines the four-year period beginning two years before the taxpayer’s stock issuance. In other words, it looks two years backward and two years forward.
Stock issued to a taxpayer may be disqualified if the company purchases more than a de minimis amount of stock from:
- The taxpayer; or
- A person related to the taxpayer under Section 267(b) or Section 707(b).
Related persons can include a spouse, siblings, ancestors, lineal descendants, and certain entities controlled by or associated with the taxpayer.
The Individual-Test De Minimis Rule
For purposes of the individual test, a redemption is more than de minimis only if:
- The aggregate amount paid exceeds $10,000; and
- The company purchases more than 2% of the stock held by the taxpayer and related persons.
Again, both thresholds must be exceeded.
The denominator here is not the total stock of the company. It is the value of all company stock held directly or indirectly by the taxpayer and related persons immediately before the purchase.
Example: A founder owns stock worth $5 million. The company repurchases $150,000 of the founder’s stock shortly before issuing the founder additional shares.
The repurchase represents 3% of the founder’s holdings and exceeds $10,000. It therefore exceeds the de minimis threshold and disqualifies stock issued to the founder during the applicable four-year period.
The repurchase may be nowhere near 2%/5% of the entire company and therefore may not trigger the company test. It can nevertheless trigger the individual test.
Service-Termination Repurchases
Fortunately, not every repurchase creates a QSBS problem.
A purchase is generally disregarded if:
- The seller received the stock in connection with services performed as an employee or director; and
- The company purchases the stock incident to the seller’s retirement or another bona fide termination of those services.
This exception is important for customary company repurchases of restricted stock when an employee leaves.
The exception does not generally cover an independent contractor who was not also a director. It also should not be assumed to protect every negotiated secondary sale involving a departing service provider. The facts should demonstrate a bona fide service termination and a sufficient connection between the termination and the repurchase.
The regulations also contain exceptions for certain repurchases connected with a stockholder’s death, disability or mental incompetency, or divorce.
Secondaries Versus Redemptions
A secondary sale directly from one stockholder to another is generally not a redemption because the company is not purchasing its own stock.
This is one reason a third-party secondary can be preferable to a company repurchase from a QSBS perspective.
However, the substance of the transaction controls. A transaction may present redemption risk if the company funds the purchase, indirectly acquires the shares, or participates through a related structure. The commonly used “magical exchange structure” comes with this risk. See Secondary Purchase plus Exchange | Baker Tax Law
The Most Common Situations
Here are several situations in which the significant redemption rules commonly arise:
- A founder wants partial liquidity at the time of a financing.
- A company repurchases shares from a departed founder.
- The company conducts a tender offer for employees.
- An early investor asks the company to buy back its shares.
- The company cleans up its capitalization table before a financing.
- A company repurchases shares shortly before issuing new founder, employee, or investor stock.
Bottom Line
The significant redemption rule is one of the easiest QSBS requirements to overlook.
A company can satisfy the C corporation, gross-assets, original-issuance, holding-period, and active-business requirements—and still disqualify an issuance because of an unrelated stock repurchase.
The best time to analyze the rule is before the company signs a repurchase agreement or launches a tender offer. Once the redemption occurs, waiting out the blackout period may be the only clean solution.
Mike Baker frequently advises with respect to qualified small business stock. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.