Key risks
1. Aggressive structuring
Some taxpayers may attempt to qualify stock or manipulate entity structures in ways that stretch the intent of section 1202.
One example involves funding a company just under the $75 million gross asset threshold at incorporation, and then almost immediately borrowing funds and acquiring assets that push it well over the limit—all pursuant to a prearranged plan. While technically the gross asset test applies at the time of stock issuance, the IRS may view such pre-planned maneuvers as abusive, subject to step-transaction doctrine, substance over form, or even the section 269 anti-abuse provisions.
Other areas could include the treatment of QSB following stock held by a private equity fund that undergoes a fund continuation, qualification of the active business requirement through investments in certain pass-through entities, the treatment of certain SAFE (simple agreement for future equity) investments, convertible debt, and qualification of management fees for certain “friendly” disqualified service businesses (e.g. engineering and medical practices) where the entity earning management fees effectively controls the professional practice.
2. Documentation failures
Section 1202 offers one of the most powerful benefits of the tax code—yet many taxpayers fail to properly document their eligibility. A common issue arises when shareholders claim the QSBS exclusion on gains passed through from partnerships or S corporations but lack visibility into whether the underlying stock actually qualifies.
In these cases, shareholders often rely on a basic qualification letter from the issuing company, which may be incomplete, outdated, or entirely incorrect. Without detailed support regarding original issuance, gross asset levels, and active business requirements, the IRS may disallow the exclusion—even if the shareholder acted in good faith.
Case in point: In Ju v. United States, poor recordkeeping led to disqualification of QSBS benefits, underscoring the importance of thorough and accurate documentation at both the entity and shareholder levels.
3. State-level discrepancies
States such as California and Pennsylvania do not conform to federal QSBS rules, creating a false sense of tax savings that may not materialize at the state level.
4. Future Treasury and IRS guidance
With the expanded benefit, there is always the risk that the U.S. Department of the Treasury and IRS could issue more robust guidance clarifying the rules, which could serve to either support or restrict certain positions being claimed by taxpayers in calculating the exclusion. As with the IRS’s crackdown on employee retention credits, captive insurance, and conservation easements, section 1202 could become a target if perceived as abusive.
Lessons from past IRS enforcement
Micro-captive insurance
In Syzygy Ins. Co. v. Commissioner, the Tax Court ruled that the captive arrangement lacked economic substance and did not constitute valid insurance. The IRS now designates certain micro-captive transactions as listed transactions, requiring disclosure and subjecting them to heightened enforcement.
In a 2025 settlement with Alta Holdings, the IRS pursued penalties under section 6700 against promoters of abusive captive structures, reinforcing its aggressive stance.
Employee retention credit (ERC): A cautionary tale
Originally designed for pandemic relief, the ERC became a magnet for opportunistic advisors. Many businesses filed questionable claims based on overly broad interpretations or misleading marketing. In response, the IRS launched a sweeping enforcement campaign, including audits, disallowances and penalties.
Just like with the ERC, we are now seeing a proliferation of online advisors offering guidance on QSBS planning—some of it aggressive or poorly substantiated. Companies and shareholders should carefully vet their advisors and positions to avoid a repeat of the past. What begins as a legitimate incentive can quickly become a minefield if misused or overpromoted.
In 2023–2024, the IRS even paused processing new ERC claims to address the surge in potentially fraudulent filings. The QSBS landscape could face similar scrutiny if taxpayers interpret the rules too broadly.
