Tax
QSBS Redemption Rules: How One Company Buyback Can Disqualify Every Share Issued That Year
Section 1202(c)(3) can void QSBS for every share issued in a 24-month band around a company buyback. Here is how the 5% significant redemption test works.
By 409.AI Team - 2026-08-26
# QSBS Redemption Rules: How One Company Buyback Can Disqualify Every Share Issued That Year
Most founders learn the Section 1202 checklist in roughly the same order. C corporation. Original issuance. Gross assets under the ceiling. Active business. Hold for five years. The redemption rules almost never make that list, and they are the only test on it that a company can fail by accident, in a single afternoon, on behalf of shareholders who had nothing to do with the transaction.
Here is the mechanic in one sentence. If a corporation buys back its own stock in the wrong amount at the wrong time, stock the company issues around that buyback is not qualified small business stock. Not reduced. Not partially excluded. Not QSBS at all.
The stakes went up in 2025. After the One Big Beautiful Bill Act, the flat per-issuer cap rose to $15 million for stock acquired after July 4, 2025, the gross assets ceiling rose to $75 million, and partial exclusions now start at a three-year hold instead of five. We wrote about [what OBBBA changed about Section 1202](https://409.ai/articles/qsbs-one-big-beautiful-bill-act-section-1202-changes) in detail. What the law did not touch is Section 1202(c)(3), and a bigger exclusion means a tainted share class now costs more.
Two rules, and the second one is the dangerous one
Section 1202(c)(3) contains two separate tests. They use different windows, different measuring sticks, and, critically, they punish different people.
The related-party test: your shares, your problem
Under [Section 1202(c)(3)(A)](https://www.law.cornell.edu/uscode/text/26/1202), stock you acquire is not QSBS if, at any time during the four-year period beginning two years before that stock was issued, the company purchased any of its stock from you or from a person related to you within the meaning of Section 267(b) or 707(b).
Treasury regulations soften this with a de minimis rule that has two prongs, and a purchase has to clear both to count. Under [Treas. Reg. 1.1202-2(a)(2)](https://www.law.cornell.edu/cfr/text/26/1.1202-2), the purchase matters only if the aggregate amount paid exceeds $10,000 and more than 2% of the stock held by you and your related persons is acquired. Multiple purchases get added together.
This test is bad news for one shareholder at a time. If the company bought $500,000 of stock back from you in 2024 and issued you new shares in 2025, your new shares are the ones that fail. Nobody else on the cap table is affected.
The significant redemption test: everyone's shares, one window
The second test is the one that gets missed. Under Section 1202(c)(3)(B), stock issued by a corporation is not QSBS if, during the two-year period beginning one year before the issuance, the corporation made one or more purchases of its own stock with an aggregate value exceeding 5% of the aggregate value of all of its stock as of the beginning of that two-year period. The regulation applies its own de minimis floor: the amount paid has to exceed $10,000 and more than 2% of all outstanding stock has to be purchased.
Read the subject of that sentence again. It is not "stock acquired by the taxpayer." It is "stock issued by a corporation." One oversized buyback taints every share the company issues in a 24-month band around it, for every founder, employee and investor in that band, whether or not any of them sold a single share.
Holland & Knight put it plainly in an October 2025 client alert: the redemption limits [remain a trap for the unwary](https://www.hklaw.com/en/insights/publications/2025/10/redemption-limitations-remain-a-trap-for-the-unwary) despite the Section 1202 expansion. The rules are mechanical. Intent is irrelevant, and so is the fact that nobody in the room was trying to game anything.
Running the 5% math
Numbers make this concrete. Take a company whose stock is worth $60 million in aggregate in January 2025. It raises a priced round that March and its aggregate value climbs to $90 million. In June 2025, the board approves a liquidity program and the company spends $4.2 million of its own cash buying shares back from a group of angels and early employees, all of whom are staying with the business.
Now test three future issuances.
Stock issued in January 2026. The testing window runs from January 2025 through December 2026, so the June 2025 buyback sits inside it. The denominator is the aggregate value of all stock at the *start* of that window, which is the $60 million figure from January 2025. That puts the buyback at 7% of company value. Over the line. Those shares are not QSBS.
Stock issued in May 2026. The window opens in May 2025, after the March round, when aggregate value was $90 million. The same $4.2 million buyback is now 4.7%. Assuming no other purchases fell in that window, those shares are fine.
Stock issued in July 2026. The window opens in July 2025, a month after the buyback closed. The buyback is outside the window entirely and does not enter the test.
Three issuances, one buyback, three different answers. The denominator moves because it is pinned to the start of each issuance's own two-year window, so a fast-growing company can fail the test on Monday's grant and pass it on a grant made four months later.
That also means the test runs on valuation numbers. The statute asks for the aggregate value of all of the corporation's stock without handing you a methodology for producing it, which is why the companies that survive this analysis are the ones with contemporaneous, defensible valuations sitting in a folder rather than a number someone reconstructed years later. If you have not thought about the difference between a board's working number and a supportable fair market value conclusion, our piece on [409A valuations versus fair market value](https://409.ai/articles/409a-valuation-vs-fair-market-value) is the place to start.
What does not count as a redemption
Plenty of ordinary startup housekeeping falls outside these rules, and knowing which parts do is most of the practical value here.
Treas. Reg. 1.1202-2(d) disregards several purchases. Stock acquired by the seller in connection with services as an employee or director, bought back on retirement or another bona fide termination of those services, does not count. Neither does a purchase from a decedent's estate, beneficiary, heir or surviving spouse made within three years and nine months of death, a purchase incident to the disability or mental incompetency of the selling shareholder, or one incident to divorce within the meaning of Section 1041(c).
So the routine repurchase of unvested shares when an employee leaves in month seven is not what this rule is aimed at. Worth noting, though: the regulation names employees and directors, and it does not name independent contractors. Holland & Knight flagged that gap in the alert above, so a contractor buyout deserves a conversation with counsel rather than an assumption.
The identity of the buyer matters just as much as the reason. Section 1202(c)(3) keys on purchases by the issuing corporation. When an outside fund buys shares directly from employees in a third-party tender, the company is not the purchaser and this rule is not triggered by the purchase. Fund the same liquidity out of the company's balance sheet and you are squarely inside it. That structural fork is worth raising before term sheets circulate, not after, and it sits alongside the other reasons [tender offers and secondary sales move your 409A](https://409.ai/articles/tender-offers-secondary-sales-409a-valuation).
One anti-abuse wrinkle: under Section 1202(c)(3)(C), a transaction treated as a redemption distribution under Section 304(a) counts as a purchase by the corporation for both tests. Routing a buyback through a related corporation does not make it disappear.
Where this actually bites
The pattern that catches companies most often is the company-funded employee liquidity program timed to a financing. Everyone is focused on the round, the buyback is a line item in the same board package, and nobody runs a 12-months-back, 12-months-forward test on the issuance the round will produce.
The second pattern is the negotiated exit of an early shareholder. A settlement with a departing investor is still a purchase of stock. So is a recapitalization that retires an old preferred series. And a founder who has already stopped working at the company occupies genuinely uncertain ground: the termination exception is written around stock acquired for services and bought back incident to a bona fide termination of those services, which is a facts-and-circumstances question, not a checkbox.
Selling shareholders have their own analysis to run, since [a secondary sale carries its own QSBS and tax consequences](https://409.ai/articles/secondary-sale-startup-shares-qsbs-tax-treatment), and buyers should know that shares bought from another shareholder never qualify as QSBS in their hands anyway, because they were not acquired at original issuance. If a sale is happening before the holding period is satisfied, [Section 1045 rollovers](https://409.ai/articles/section-1045-qsbs-rollover-defer-gain-early-sale) are the pressure valve worth understanding first. And investors holding unconverted instruments should remember that [a SAFE's clock does not start until conversion](https://409.ai/articles/safes-qsbs-holding-period-conversion-section-1202), which puts many conversions inside exactly the windows this article is about.
The record that makes this survivable
Keep a redemption log from the day the company forms. For every purchase of the company's own stock: date, seller, whether the seller is related to any other shareholder under Section 267(b) or 707(b), the amount paid, the percentage of outstanding stock it represented, the aggregate value of all stock at the relevant window starts, and the exception relied on if any.
Then add one step to the buyback approval process. Before the board signs, ask what the company plans to issue in the next 12 months and what it issued in the last 12, and run the 5% test against those dates. If the answer is close, the fixes are usually easy while the deal is still on paper: resize the buyback, move it a quarter, or find a third-party buyer for the shares.
State treatment is a separate question, and a shareholder who clears every federal test can still owe state tax, which we walked through in [QSBS and state conformity](https://409.ai/articles/qsbs-state-tax-conformity-california-new-jersey).
Section 1202 is unusual in that a shareholder's exclusion can turn on a transaction they never participated in and may never have heard about. Before your company writes a check for its own stock, put that closing date on a calendar and draw two lines: twelve months back, twelve months forward. Everything issued inside that band is riding on the 5% math, and the time to get the valuation and the paperwork right is while the buyback is still a proposal.
If you are building the documentation to support a Section 1202 position, a [QSBS attestation letter](https://409.ai/products/qsbs) and a defensible [409A valuation](https://409.ai/products/409a) are the two files a diligence team will ask for first.