Stock Redemptions, Buybacks, “Anti-Churning”, and QSBS

Lately, we’ve spoken with several potential partners facing—or planning—redemptions and stock buybacks, which brings up a critical issue: maintaining QSBS eligibility and avoiding some often-unknown traps. A key but much-overlooked risk is the anti-churning rule, which, if triggered, can strip stock of its QSBS status and the tax advantages that come with it.

Why the Anti-Churning Rule Exists

The IRS implemented anti-churning provisions under Section 1202(c)(3) to prevent companies from executing transactions designed to convert non-QSBS stock into QSBS. These rules primarily restrict redemptions during certain time periods around QSBS issuances, meaning companies need to be careful about how and when they buy back stock or issue new shares to investors.

How to Avoid Losing QSBS Status

Being mindful of the four-year and two-year testing periods is crucial for companies aiming to maintain QSBS eligibility. Under Section 1202(c)(3)(A), if a company redeems stock from a taxpayer or a related person within a four-year period—beginning two years before and ending two years after a QSBS issuance—the stock forfeits its QSBS status. Additionally, Section 1202(c)(3)(B) states that if a company repurchases stock exceeding 5% of its aggregate value within a two-year period (starting one year before and ending one year after a QSBS issuance), the stock may also lose its QSBS eligibility. Before proceeding with a redemption, it is essential to check whether a QSBS issuance falls within these windows to avoid unnecessary risks.

Redemptions should also be kept within safe limits to prevent disqualification. If a company redeems stock exceeding $10,000 or involving more than 2% of a stockholder’s holdings (or the company’s total outstanding stock) within a testing period, QSBS status may be jeopardized. To mitigate this risk, companies should ensure any necessary redemptions remain below these thresholds.

Where possible, companies should encourage secondary sales instead of redemptions. When investors sell shares to other investors rather than back to the company, it prevents a redemption event that could impact QSBS eligibility. Structuring these transactions as private sales between shareholders instead of corporate buybacks is a practical way to reduce risk.

Certain exemptions exist that allow redemptions to avoid triggering the anti-churning rules. Stock repurchases related to employment termination (including resignations, retirements, and layoffs) are excluded. Similarly, redemptions due to death, disability, or divorce are also exempt. If a buyback falls into one of these categories, companies should document the reason carefully to ensure compliance.

Planning ahead for liquidity events and capital restructuring is another key consideration. Companies offering liquidity through stock buybacks must account for the QSBS testing windows and ensure that redemptions do not compromise shareholders’ tax benefits. Proper planning allows businesses to align capital-raising and buyback strategies with QSBS eligibility rules, maintaining tax advantages for investors.

Lastly, companies must be strategic about the timing of buybacks and new issuances. Issuing QSBS too soon before or after a redemption can disqualify stock from QSBS treatment. Additionally, transactions classified as redemptions under Section 304(a)—such as certain stock acquisitions within affiliated groups—are considered purchases for anti-churning purposes, which could impact QSBS eligibility. Developing a clear timeline for issuing and redeeming stock ensures compliance and preserves QSBS benefits.