Section 1202 requires stock in a C corporation for federal tax purposes. Interests in a partnership-taxed or disregarded LLC, and stock issued while an S election is effective, do not qualify. A qualifying incorporation of an LLC can start a QSBS holding period; merely revoking an S election does not qualify the existing shares. Entity choice and tax classification both matter if venture capital or a significant exit is on your roadmap.
For the full eligibility rules, see QSBS & Section 1202: The Complete Founder's Guide. This post covers one requirement — C corporation status — because it's the one you can't fix retroactively.
What C-Corp Status Is Worth
Assume an individual founder acquires qualifying stock for nominal basis, satisfies every QSBS requirement, holds it more than five years, and sells for $16 million. Assume no prior use of the issuer’s dollar limit and a 23.8% federal rate on taxable gain outside that limit. The comparisons use the initial statutory dollar amounts, ignore future inflation adjustments, and are simplified federal illustrations rather than tax-return calculations.
Without §1202: federal long-term capital gains tax at 23.8% (20% rate plus the 3.8% net investment income tax) is about $3.8 million. You net roughly $12.2 million before state tax.
With §1202 under the older acquisition regime: Assume statutory acquisition after September 27, 2010 and on or before July 4, 2025. With nominal basis and an unused $10 million dollar limit, the founder excludes $10 million and pays about $1.43 million on the remaining $6 million at the assumed 23.8% rate. Net proceeds are roughly $14.6 million, and federal savings are about $2.4 million. Older acquisitions require their historical exclusion-percentage analysis.
With §1202 under the newer acquisition regime: For statutory acquisition after July 4, 2025, use the initial $15 million dollar component in this illustration. Excluding $15 million leaves $1 million taxable at the assumed 23.8%, for $238,000 of federal tax and about $3.6 million of savings. The $15 million amount is indexed beginning in 2027; the ten-times-basis multiplier is not. Prior use and mixed-regime coordination can reduce the available dollar amount.
For an investor, $2 million of qualifying basis in the shares sold during the year produces a $20 million eligible-gain limit under the ten-times-basis alternative. The amount actually excluded still depends on the applicable holding-period percentage and other requirements. Model your own numbers with the QSBS calculator.
These benefits are unavailable for interests issued while an LLC is taxed as a partnership or disregarded entity, or for stock issued while an S election is effective. An LLC classified as a C corporation for federal tax purposes is not disqualified merely because its state-law form is an LLC. See Treasury Regulation §301.7701-3.
Why Only C-Corporations Qualify
Section 1202(c)(1) requires stock in a C corporation acquired at original issuance, and §1202(c)(2)(A) requires the issuer to be a C corporation during substantially all of the taxpayer's holding period. Congress built the exclusion to push long-term capital into closely held C-corps; pass-through owners already avoid entity-level tax, so they were left out of the bargain.
What that means by entity:
- LLC: No QSBS for partnership-taxed, disregarded or S-elected interests. An eligible LLC can instead elect C-corporation tax classification; equity issued under that classification must still satisfy all Section 1202 requirements.
- S-corp: stock issued while an S election is in effect is not C corporation stock at issuance. Revoking the election later doesn't cure it — issuance is tested when the stock is issued, and a mid-hold S election can independently violate §1202(c)(2)(A).
- Partnership / sole proprietorship: no stock at all. No QSBS.
- C-corp: Potentially eligible if all tests are met, including gross assets not exceeding the applicable $50 million or $75 million ceiling, qualifying original issuance, active qualified business and holding period. The detailed historical and after-issuance tests appear below.
The LLC-to-C-Corp Conversion: What You Keep and What You Lose
Founders often start as LLCs for pass-through losses and simplicity. Converting to a C-corp often proceeds as a Section 351 exchange, but merely forming a corporation does not automatically satisfy §351. Section 351 generally provides nonrecognition when one or more persons transfer property to a corporation solely in exchange for its stock and, immediately after the exchange, the transferors are in control of the corporation within §368(c)—at least 80% of the total combined voting power of all classes of voting stock and at least 80% of the total number of shares of each other class of stock. Nonrecognition defers gain through the basis rules; it does not make the transaction permanently tax-free. Stock issued for services is not treated as issued for property for §351 purposes under §351(d), though a person who contributes both property and services can still matter to the control analysis under the applicable rules. When the exchange qualifies, the shares issued at conversion are original-issuance C corporation stock and can qualify as QSBS from the conversion date if the other §1202 requirements are met.
Two costs come with the late start:
- The QSBS clock starts at incorporation. When property other than money or stock is exchanged for qualifying C-corporation shares, §1202(i)(1)(A) starts the Section 1202 period on that exchange date. Time operating the business as a partnership-taxed or disregarded LLC does not count. Apply the acquisition regime and exact holding-period requirement to the resulting shares.
- Pre-conversion appreciation remains outside the exclusion. Section 1202’s special fair-market-value basis limits the appreciation eligible for exclusion. It does not generally increase regular tax basis or eliminate the built-in gain deferred at incorporation. The example below shows how that works. See §1202(i) and §358.
One contribution, three basis figures, two different exits
Assume you contribute property with $1 million of adjusted tax basis and $5 million of fair market value to a C corporation solely in exchange for all its stock, and the exchange qualifies for nonrecognition under §351 (including the §368(c) control requirement). There are no liabilities, cash payments, transaction costs or other basis adjustments. Treat the two $8 million exits below as alternatives, not successive sales. If contributed property is subject to liabilities, §357(a) generally treats the corporation’s assumption as not boot, but §357(b) can recharacterize tax-avoidance or non-bona-fide assumptions, and §357(c) can force gain recognition when assumed liabilities exceed the aggregate adjusted basis of the transferred property.
| Whose basis, and in what? | Amount | What it measures |
|---|---|---|
| Corporation’s regular basis in the contributed assets | $1 million | Gain or loss when the corporation sells those assets |
| Your regular basis in the stock | $1 million | Your total gain or loss when you sell the stock |
| Your special stock basis for §1202 purposes | $5 million | The post-contribution gain potentially eligible for QSBS exclusion |
The first two figures are separate accounts: the corporation’s asset basis under §362, and your stock basis under §358, each generally carrying over from the contributed property’s adjusted basis under these assumptions. The third is a special rule for Section 1202 only. It does not reset either regular tax basis to $5 million. Separately, Section 1202’s gross-assets eligibility test generally counts the contributed property at its contribution-date fair market value; that also does not give the corporation a regular tax-basis step-up.
Exit 1: the corporation sells the assets
If the corporation later sells those assets for $8 million, its gain is $7 million: $8 million of proceeds minus $1 million of asset basis. That gain belongs to the corporation. Section 1202 does not exclude it, because this is the corporation’s asset sale, not your sale of QSBS. Any later distribution of the proceeds to you requires a separate shareholder-level tax analysis; a corporate asset sale and a shareholder stock sale are not equivalent.
Exit 2: you sell the stock
If you instead sell all your stock for $8 million, your total stock gain is $7 million: $8 million minus your $1 million regular stock basis. Section 1202 then asks how much of that gain is eligible for exclusion. Using the $5 million special basis, only $3 million of post-contribution appreciation is potentially eligible. The remaining $4 million is the pre-contribution appreciation and stays outside the QSBS exclusion. If you satisfy every requirement for a 100% exclusion and have enough eligible-gain capacity, you exclude $3 million and retain $4 million of taxable stock gain. At a partial-exclusion tier, some of the $3 million remains taxable too.
Why the stock buyer cares
In an ordinary stock sale with no election treating it as an asset sale, the corporation has not sold its assets. It recognizes no asset-sale gain merely because its shareholder changes, and its regular basis in the assets remains $1 million under these assumptions. The buyer generally gets an $8 million cost basis in the purchased stock, not an $8 million basis in the corporation’s assets. The company still carries the potential tax on its low-basis assets. That future tax exposure can affect what a buyer will pay; it is one reason buyers and sellers negotiate over asset-sale versus stock-sale structure.
The practical point: incorporation can defer built-in gain, and QSBS can potentially shelter later stock appreciation. Neither automatically makes the tax on the earlier appreciation disappear.
Primary sources: §351; §368(c); §357; §362; §358; §1202(i); §1012.
There's also a gross-assets wrinkle cutting the other way: convert after the business has real value and you may be closer to the $50M/$75M ceiling than a day-one incorporation would have been.
The S-Corp Trap: Why Converting Later Doesn't Help
An S election is a tax classification, not an entity. Incorporate, file Form 2553, and you are a corporation taxed as a pass-through — but stock issued during the election period is not C corporation stock for §1202 purposes. Revoking the election prospectively doesn't retroactively qualify that stock, and because §1202(c)(2)(A) tests C-corp status over substantially all of the holding period, an S election at the wrong time can disqualify stock that started clean.
If QSBS matters to you, the rule is simple: C corporation status on the day of issuance, and no S election while you hold. How prior LLC or S-corp history gets handled in the paper trail is covered in the C-corp confirmation section of a QSBS attestation letter.
Common Founder Mistakes
Starting as an LLC, planning to “fix it later.” For an LLC taxed as a partnership or disregarded entity, later incorporation does not bring the prior operating years or pre-contribution appreciation into Section 1202. Establish the intended tax classification before assuming the QSBS clock has started.
Misjudging the holding period. Statutory acquisition on or before July 4, 2025 requires more than five years for any exclusion; later acquisitions can receive 50%, 75% or 100% exclusion after at least three, four or five years. Acquisition includes applicable holding-period tacking and is not always the issuance date. For restricted stock, the holding period generally starts when the stock becomes substantially vested unless a timely 83(b) election applies, in which case the transfer controls. The election generally must be filed within 30 days after transfer, subject to applicable weekend, holiday and disaster-relief rules.
Assuming your accountant is watching this. Early-stage CPAs are doing payroll and expensing, not §1202 planning. By the time an exit-stage advisor asks about QSBS, the entity decision is years old. Raise it yourself at formation.
Restructuring under deal pressure. An LLC incorporation and a change from S to C tax status are not interchangeable. A qualifying property contribution for newly issued C-corporation stock can create a prospective QSBS opportunity; revoking an S election alone cannot qualify the old S shares. Analyze the actual transaction before promising a new clock.
Timing: What Has to Be True, and When
- C-corp at issuance — the entity question this post is about.
- Original issuance (§1202(c)(1)(B)): acquired from the company for money, property (not stock), or services — not bought from another shareholder.
- Gross assets (§1202(d)): apply the $50 million ceiling to issuances on or before July 4, 2025 and $75 million to later issuances, with indexing of $75 million beginning in 2027. The corporation and predecessors must satisfy the historical pre-issuance test, and assets immediately after issuance must include the proceeds. Apply parent-subsidiary aggregation and the special fair-market-value rule for contributed property.
- Qualified trade or business (§1202(e)(3)): most operating companies qualify; excluded fields include health, law, consulting, financial services, banking, hospitality, and farming.
- Holding period Statutory acquisitions on or before July 4, 2025 require more than five years, with historical percentages where applicable. Later acquisitions use at least three/four/five years for 50%/75%/100%. Apply statutory tacking; issuance alone does not select the exclusion regime.
When to Incorporate as a C-Corp vs. an LLC
Choose a C-corp from day one if you plan to raise institutional capital, expect a significant exit, want §1202 for yourself and your investors, or are issuing meaningful early equity to cofounders and employees. Choose an LLC if you're building a business that will distribute profits rather than exit, need early losses on your personal return, and are genuinely not on the venture path. For venture-track startups this is not a close call — the full analysis is on the entity selection page.
How OBBBA Changed the Numbers
OBBBA uses two dates. Statutory acquisition after July 4, 2025 brings the initial $15 million dollar component and the three-/four-/five-year exclusion tiers, subject to tacking and coordination. Issuance after that date brings the $75 million gross-assets ceiling. The $15 million and $75 million amounts are indexed beginning in 2027. The C-corporation tax-status requirement remains. Full analysis: OBBBA: A New Era for QSBS.
Practical Action Steps
Not yet incorporated: form a Delaware C-corp, issue founder stock immediately, and file 83(b) elections within 30 days so the holding period starts now. Note the QSBS intent in the records.
Already an LLC or S-corp with VC plans: Document the actual tax transaction. An LLC taxed as a partnership or disregarded entity may incorporate through a qualifying property-for-stock exchange. An S corporation needs a separately analyzed restructuring; merely terminating its S election does not qualify existing shares. Keep regular tax basis, the §1202 fair-market-value basis floor, the gross-assets test and the new holding period separate. The special basis does not eliminate deferred built-in gain.
Approaching an exit short of the holding period: Under the older statutory acquisition regime, exactly five years is insufficient; the holding period must exceed five years. Under the newer regime, model the three-, four- and five-year tiers. Satisfying time alone does not establish eligibility. Document the position while records are fresh — that is what a QSBS attestation letter is for.
The Bottom Line
Entity choice and federal tax classification affect the Section 1202 opportunity. Qualifying C-corporation stock can carry a substantial exclusion; partnership-taxed LLC interests and S-corporation stock cannot. An LLC taxed as a C corporation requires the same qualification analysis as other C corporations. Plan before issuing equity, and do not assume a later restructuring retroactively fixes the earlier period.
Disclaimer: This article is for general informational purposes only and does not constitute legal or tax advice. Consult a qualified attorney or tax advisor about your specific situation.
