Profitable, capital-efficient businesses, especially in software, often have a QSBS problem they don't know about.
That's a core theme from a recent episode of QSBS, Solved, where host Brady Weller talked with Blaine Woodson, a Manager in Grant Thornton's National Tax Office and one of the firm's QSBS subject matter experts. The conversation covered the Section 1202 asset test, S-Corp to C-Corp conversions, and the practical benefits driving many of these decisions. Below are the key planning points from that episode. The full conversation has more detail and context worth hearing directly. LISTEN NOW.
Section 1202 was written in 1993, when qualifying as an active trade or business generally meant holding inventory and physical assets. Modern software companies increasingly generate high margins with minimal overhead, a trend accelerated by AI reducing engineering headcount needs.
Section 1202's active business asset test requires that at least 80% of a corporation's assets be used in an active qualified trade or business. Cash counts against that test. Woodson described a client projecting $10 million in cash against $18 million in total assets, which puts the company at risk of failing the test.
There's a narrow R&D exception for a company's first two years, and a broader "reasonable working capital needs" exception after that, but the working capital exception caps cash at 50% of the balance sheet. Companies holding cash for AI infrastructure buildouts or opportunistic growth run into this cap directly.
Until Treasury issues updated regulations, Woodson's recommendation is to move cash out of the corporation through distributions or bonus compensation rather than let it accumulate.
Woodson also pointed to an overlooked asset class: goodwill and going concern value. Most early-stage companies don't get annual valuations, so a GAAP-basis balance sheet often understates the business's actual value, including value that could offset a large cash position for purposes of the 80% test.
For companies with significant revenue, Woodson recommends engaging a valuation professional to quantify goodwill and going-concern value (separate from IP) as a legitimate business asset. This comes up often in industries like pharmaceuticals, where companies need to retain cash for burn and can't simply distribute it out.
Three scenarios drive most conversions:
Family businesses moving to professional management. As multi-generation businesses shift from family-managed to professionally managed, C-Corp form tends to fit better, particularly for executive compensation.
Capital raise constraints. S-Corps limit shareholders to U.S. persons and certain specified trusts. That restriction becomes a problem once a company wants venture capital, family office capital, or foreign investment.
International tax benefits. S-Corps can't access the FDII (Foreign-Derived Intangible Income) deduction, extended under OBBBA, which lets U.S. corporations selling IP to foreign customers pay a reduced effective rate of roughly 13 to 14%, versus the standard 21% corporate rate. S-Corps also generally don't qualify for treaty benefits at the entity level, which complicates cash repatriation from foreign operations. Woodson cited one client where the combined international and QSBS benefit was projected to save about $35 million in federal income tax over five years.
There is one safe way to convert from S-Corp to C-Corp for QSBS purposes: an assets-down transaction. The S-Corp stays in place as a holding vehicle, and the business assets are contributed into a newly formed entity (an LLC electing C-Corp treatment or a state-law corporation) in exchange for stock. That new entity's stock starts the QSBS holding period.
Key points from the episode:
The episode also raised an open technical question: whether Section 1202(i) built-in gain is taxed at the standard 21% corporate rate or the higher 28% rate applied elsewhere in the code. Woodson's position, based on the statutory link between QSBS gain treatment and Section 1202(a), is that the lower rate applies, spread proportionally across shares in a partial liquidity event. It's a good example of why Treasury guidance is still needed.
Some startup advisors recommend starting a company as a pass-through entity, then converting to a C-Corp later to capture the 10x basis multiplier under QSBS rules.
Both hosts pushed back on this as blanket advice. Partnership-level complexity, capital account management, and tracking pre-contribution built-in gain create real overhead. For a fast-growth, capital-intensive business, starting directly in C-Corp form may produce a better outcome than engineering a later conversion.
Many companies aren't a clean qualified trade or business. They're tech and real estate, tech and services, or tech and insurance. The episode covered an example: a business with 80% of revenue from real estate rents and 20% from a supporting tech platform, where growth potential was concentrated in the software side.
The solution was a bifurcated structure: the software business became its own C-Corp (via an LLC check-the-box election) to access QSBS treatment and FDII benefits on cross-border licensing, while the real estate stayed in a separate passive vehicle. Real estate generally doesn't belong inside a QSBS-qualifying corporate structure. The tradeoff is that transfer pricing between the entities has to be documented properly, both domestically and internationally.
The same issue applies to consulting-heavy tech businesses. Any company delivering a custom enterprise solution is, to some degree, also a consulting business, which raises its own gray-area questions under Section 1202.
Getting this right requires corporate counsel and tax advisors working together from the start: corporate counsel protecting the commercial deal, and tax advisors making sure the conversion mechanics, valuation, and built-in gain calculation hold up under Section 1202.
This article covers the main points. The full episode of QSBS, Solved with Blaine Woodson includes more detail. Check it out here, or wherever you listen to podcasts.
Disclaimer: This article and referenced podcast are for general informational and educational purposes only and does not constitute tax, legal, financial, investment, or other professional advice. Some information may be outdated or feature technical inaccuracies.
