In a prior newsletter article (2023 Q4.2), we outlined how Qualified Small Business Stock (QSBS) can be a powerful tool for certain taxpayers, and proper documentation and technical analysis are important to ensuring that your QSBS position can withstand an IRS challenge. This article explores how a proper company valuation and maintaining thorough documentation help support a QSBS position, especially in light of legislative changes under the One Big Beautiful Bill Act. 

Refresher on QSBS

QSBS is a type of stock issued by certain qualified small businesses that meet a few requirements. First, the company must be organized as a domestic C corporation with no more than $75 million of aggregate gross assets at the time of stock issuance (for stock issued after July 4, 2025) or $50 million of aggregate gross assets (for stock issued before July 5, 2025). After 2026, the $75 million threshold will be adjusted for inflation. Second, the stock must be acquired by the taxpayer directly from the company at its original issuance for money, for property other than stock, or as compensation for certain services. Lastly, the stock must be held by the taxpayer for a specified period of time, generally at least three years for stock issued after July 4, 2025, and at least five years for stock issued before July 5, 2025.

For stock issued after July 4, 2025, the taxpayer may be eligible to exclude 50% of the gain from the sale of the stock for stock held for three years, 75% for stock held for four years, and 100% for stock held for five years or more, assuming the above conditions are met. This exclusion is subject to a maximum amount equal to the greater of $15 million (adjusted for inflation after 2026) or 10 times the taxpayer’s QSBS basis in the stock sold. For stock issued after September 27, 2010, and before July 5, 2025, a $10 million or 10 times basis rule applies. Other exclusion rules apply for stock issued in significantly earlier years.

LLC to C Corporation Conversions

Small businesses are often established as pass-through entities such as limited liability companies (LLCs). This is often the case, so that losses expected in the company’s early years can flow to the owners. However, third-party investors such as venture capital and angel investors often prefer to invest in C corporations for a variety of reasons, including the ability to issue multiple classes of stock with different rights and preferences. Often, small businesses will convert from an LLC to a C corporation to grow and secure additional capital.

When an LLC converts to a C corporation, the owners of the LLC contribute their units to the C corporation in exchange for stock. For many businesses, this conversion occurs commensurate with an outside round of equity financing. The taxpayer is only eligible for QSBS treatment to the extent that the fair market value (FMV) of the total gross assets being contributed to the C corporation is equal to or less than $75 million at the time of the conversion (for stock acquired after July 4, 2025 – adjusted for inflation) or $50 million (before July 5, 2025). Therefore, the taxpayer must determine whether the FMV implied by the financing round will result in a conversion value that exceeds the threshold amount.

Pre-money and Post-money Valuations

Investors often speak about pre-money and post-money valuations. What taxpayers may not realize is that a pre-money valuation is not necessarily equivalent to the FMV of the company before the financing round. A pre-money valuation assumes that all the shares of a company are valued equally at the price of the new financing round. However, different classes of stock (e.g., common and preferred stock) may hold different values as a result of the rights and preferences that accrue differently to each class. As a result, the company value before the financing round may be equal to or less than the pre-money valuation.

Below are two examples: one in which an outside investor buys common shares (Scenario 1) and one in which the investor buys preferred shares (Scenario 2). For purposes of these illustrations, it is assumed that the company’s gross assets and total equity value are equal (i.e., the company has no liabilities). Additionally, in each scenario, the company’s pre-financing capitalization structure consists of 10 million common shares outstanding (Note A).

In Scenario 1, the investor buys four million common shares at $5 per share (Note B). Because the investor is buying the existing and only outstanding class of shares—common shares—the price per share of the investment is a relevant indication of value in estimating the FMV of the total company’s equity. In this case, the pre-money valuation of $50 million (Note C) is the same as the FMV of total equity (Note D) for purposes of the QSBS test.

In Scenario 2, the investor buys four million preferred shares at $5 per share (Note E). Preferred shares often accrue different rights and preferences than common shares, which might include liquidation preferences, dividends, enhanced voting rights, conversion features, etc. Investors generally value preferred shares higher than common shares because of these benefits. In Scenario 2, the pre-money valuation is identical to Scenario 1—$50 million (Note F) —because a pre-money valuation assumes that all company shares have a value identical to the latest class of equity issued. However, because of the differences in rights and preferences, the common share value is estimated at something less than $5, or $3 in this example (Note G). As a result, the FMV of total equity under Scenario 2 is $30 million (Note H), not $50 million.

The Takeaway

Proper company valuation is a critical component of QSBS. The taxpayer must have a reasonable basis of value when stock is received from the C corporation to ensure that the gross assets test is met. Additionally, the valuation at the time of the LLC to C corporation conversion establishes the QSBS tax basis for the taxpayer. Maximum QSBS benefit is calculated as the greater of $15 million, adjusted for inflation (for stock acquired after July 4, 2025; $10 million for stock acquired before July 5, 2025), or 10 times the taxpayer’s basis of all shares sold during the tax year. In the example below, the tax bases range from $30 million to $50 million, implying a maximum QSBS benefit of $300 million to $500 million for the shareholders of the company.

Given the favorable tax treatment of QSBS, the inherent complexities, and the broadening base of taxpayers benefiting from this provision, IRS scrutiny has increased in recent years. It is important that taxpayers sufficiently document the value of their stock and, consequently, their tax basis in the stock, to ensure that QSBS tax positions withstand potential IRS scrutiny.

The simplified examples below illustrate how valuation conclusions may differ depending on the class of equity issued.