Qualified small business stock: The trap for foreign entities restructuring into a US corporation  

Sec. 1202 offers a compelling tax benefit: exclusion of up to 100% of the gain from the sale of qualified small business stock (QSBS) that has been held for at least five years. For eligible taxpayers with sufficient gain, the gain exclusion is the greater of $10 million per issuer or 10 times their stock basis (and with proper planning can be expanded even further). In addition, the law commonly known as the One Big Beautiful Bill Act, H.R. 1, P.L. 119-21, amended Sec. 1202 to also allow a 50% gain exclusion for QSBS acquired after its date of enactment (July 4, 2025) and held for at least three years, which increases to 75% if held for at least four years. The act also increased the per-issuer limitation to $15 million, adjusted for inflation after 2026, for QSBS acquired after July 4, 2025.

This Code provision has become a focal point for founders, early-stage investors, and advisers looking to optimize exit strategies (see also Veniskey, “Investments in Qualified Small Business Stock,” 51 The Tax Adviser 791 (December 2020)).

However, one category of stockholders often misses out on the benefits of Sec. 1202: owners of a foreign entity that restructures into the United States by putting the foreign entity under a U.S. corporation. This restructuring may irreparably taint QSBS eligibility of the corporation’s shares on Day 1, for reasons discussed below.

The restructuring scenario

Suppose a foreign entity is preparing to attract U.S. capital by restructuring into the United States. On the advisers’ recommendation, the following sequence of steps is taken:

• A new U.S. corporation is formed (U.S. Holdco).
• The shareholders of the foreign entity contribute their equity to the new U.S. corporation.
• In exchange, those shareholders receive newly issued stock of the U.S. corporation.

As a result, U.S. Holdco owns 100% of the foreign entity, and the original foreign shareholders now own U.S. Holdco. The goal is to “domesticate” the structure, with the primary driver typically being access to the U.S. capital market. It is also expected to be a tax-free transaction from a U.S. point of view, under Sec. 351.

Everything looks clean, and the startup has accomplished its goal. But down the line (often years later), when stockholders are looking at a liquidity event, someone will ask: Does the stock of U.S. Holdco issued to the shareholders of the foreign entity as part of the restructuring qualify as QSBS under Sec. 1202?

Stock for stock does not qualify

Sec. 1202(c)(1)(B) provides that stock is QSBS only if it is originally issued “in exchange for money or other property (not including stock), or as compensation for services” (emphasis added). Stock issued in exchange for other stock is categorically excluded from being QSBS.

The restructuring has caused a serious problem for the early-stage stockholders. U.S. Holdco issued its stock in exchange for the stock of the foreign entity — not for money, not for property, and not for services. This means that, from inception, U.S. Holdco stock issued in the restructuring is not — and never will be — QSBS under Sec. 1202.

Why this matters

To be clear, stockholders who do not pay income tax in the United States generally have no interest in Sec. 1202, as they are already not paying U.S. tax on capital gains. However, for shareholders who become U.S. taxpayers after the restructuring — especially founders or early investors — this mistake can cost them. Many may assume that simply holding U.S. corporation stock for the requisite number of years will entitle them to the Sec. 1202 exclusion. But if the stock was issued in a stock-for-stock exchange, no holding period will ever cure the defect.

Even worse, this issue may not be discovered until an exit is on the horizon — when it is too late to restructure.

Potential workarounds and planning opportunities

There are options, albeit limited ones, to preserve Sec. 1202 eligibility in these cross-border scenarios.

Pre-restructuring entity classification election: If the foreign entity is eligible to be treated as a disregarded entity or partnership for U.S. federal income tax purposes (e.g., in an election via Form 8832, Entity Classification Election), then the equity of the foreign entity will not be treated as “stock” for U.S. federal income tax purposes. This would allow U.S. Holdco to issue stock in exchange for “property,” avoiding the stock-for-stock problem in Sec. 1202(c)(1)(B).

Asset transfer instead of stock transfer: The foreign entity could contribute assets (rather than equity) directly to the U.S. corporation in a transaction qualifying under Sec. 351. Again, this permits issuance of stock for property rather than stock for stock. However, foreign legal and tax consequences, as well as other disruptions (such as dealing with the transfers of contracts), must be carefully evaluated.

Issue additional stock for something other than stock: While the stock issued for foreign stock is not eligible for QSBS benefits, newly issued stock can be. For example, stock issued by U.S. Holdco as a grant to a founder for services does not suffer from the same stock-for-stock problem, notwithstanding that it is held by the same person as other stock not eligible for QSBS benefits.

Incorporate the U.S. entity from the outset: Where possible, starting with a U.S. C corporation may be the cleanest way to ensure eligibility for Sec. 1202 from Day 1. For venture-backed startups or intellectual property–heavy businesses, this can be a key consideration in initial formation decisions.

Plan before restructuring

Sec. 1202 offers a remarkably valuable tax benefit, but following its requirements is necessary to get that benefit. Structuring matters — and a common cross-border reorganization can doom QSBS treatment before the holding period for the requisite number of years even begins. Advisers must take care when foreign equity is involved, particularly when shares of a U.S. corporation are issued for other stock. With thoughtful planning — ideally in advance of the initial restructuring — these pitfalls can be understood and, hopefully, avoided.

— T.J. Wilkinson, J.D., LL.M., is a shareholder with Shulman Rogers PC in Potomac, Md. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.