Does a Last-Minute Stock Purchase Before Liquidation Qualify for QSBS or Give a Loss?

A tax professional asked on Reddit about a client who was a shareholder in a tech startup (started around 2019), paid $0 for his initial shares, and worked as a W-2 employee at a reduced rate. The tech company folded mid-2024. The client had a "due to me" note of $30,000 for expenses paid on behalf of the company and wanted to take a loss and mentioned QSBS and ordinary loss. At tax time the client produced a restricted stock purchase agreement dated 9/24/24 (30,000 shares for $30,000) and a Board Action with plan of liquidation and dissolution dated 12/24/24. The tax pro asks: Does this qualify for QSBS? It doesn't pass the sniff test. QSBS does not apply here: it's a gain exclusion for stock held more than 5 years; there's no gain (stock worthless) and no 5-year hold. A loss requires basis; the 9/24 purchase might give $30k basis if it's a bona fide purchase, but the timing (liquidation 3 months later) and match to the note support substance/step-transaction concerns. Worthless stock is a capital loss under § 165(g); ordinary loss is only possible under § 1244 if the stock qualifies.

Bottom line: QSBS (IRC § 1202) does not apply to losses; it excludes gain on sale of qualified stock held more than 5 years. Here there is no gain and no 5-year hold, so QSBS is irrelevant. The client can only claim a loss if he has basis. The 9/24/24 purchase could establish $30k basis if it was a real purchase (e.g., debt-for-stock), but the timing (purchase then liquidation within months) and the match to the "due to me" note support an IRS argument that the transaction lacked substance or was a step to create a loss, so basis could be challenged. If he has basis, worthless stock is capital loss under § 165(g); ordinary loss is possible only under § 1244 if the stock qualifies. Get corporate and tax advice, document substance, and consider disclosure if taking the position.

Question from Reddit

Question from tax pro re: QSBS

Client was a shareholder in a tech startup that started around 2019. I believe he paid zero dollars for his initial shares. He worked as a W2 employee at a reduced rate. Tech company folded mid-2024.

Client asked about taking a loss on the tech company mid-2024 and I said: "my understanding is that you have no basis to write off. You had no investment in the company". His response "There is a due to me note in the amount of $30,000 on the balance sheet for expenses I paid on behalf of the company". He mentioned QSBS and that he wanted to take an ordinary loss. I said he needed to get legal and tax help at the corporate level as part of the wind down because I wasn't sure if this would qualify or not.

Come tax time he gave me a restricted stock purchase agreement dated 9/24/24 showing purchase of 30,000 shares for $30,000. Then a Board Action with plan of liquidation and dissolution dated 12/24/24.

Does this qualify for QSBS? It doesn't pass the sniff test for me but I can't find anything definitive to say why.

Your thoughts please?

Source: Reddit

Analysis

The tax pro has a client who (1) had no cost basis in his original startup shares, (2) had a $30k "due to me" note (expenses paid on behalf of the company), (3) then produced a 9/24/24 restricted stock purchase for $30,000 (30,000 shares) and a 12/24/24 Board Action approving liquidation and dissolution. The client wants QSBS treatment and an ordinary loss. The tax pro is skeptical (sniff test) and wants to know whether this qualifies for QSBS and why it might not. Key distinctions: QSBS (IRC § 1202) is an exclusion of gain on sale of qualified stock held more than 5 years; it does not create an ordinary loss. For a loss, the relevant rules are worthless stock (IRC § 165(g)), generally capital loss, and IRC § 1244 (small business stock), which can allow ordinary loss subject to limits. Basis is required for any loss; the $30k purchase in September 2024 right before liquidation in December 2024 raises substance, timing, and step-transaction concerns.

Answer

QSBS vs. loss: two different things

QSBS (IRC § 1202) allows an exclusion of gain (50%, 75%, or 100%) when you sell qualified small business stock that you've held more than 5 years. It does not apply to losses and does not turn a loss into ordinary loss. So when the company folds and the stock becomes worthless, there is no gain to exclude; QSBS is irrelevant for the loss. The client's hope for "QSBS" and "ordinary loss" mixes two different regimes: QSBS = gain exclusion (and requires more than 5 year hold); ordinary loss on small business stock = IRC § 1244 (if the stock qualifies).
Worthless stock: When stock becomes worthless, IRC § 165(g) treats it as a sale or exchange on the last day of the taxable year, giving you a capital loss (short-term or long-term depending on holding period). So the client gets a loss only if he has basis; the character is capital unless § 1244 applies.
Ordinary loss: IRC § 1244 can allow ordinary loss on small business stock (stock of a small business corporation issued for money or property, subject to dollar and other limits). That is separate from QSBS. So the right questions are: (1) Does the client have basis? (2) Is the loss capital (§ 165(g)) or potentially ordinary (§ 1244)? (3) Was the stock ever QSBS? (Only matters if there were gain and more than 5 year hold; not the case here.)

Does the 9/24/24 purchase give him basis?

For a loss, the client needs basis in the stock. He originally had $0 cost for his shares. The "due to me" $30,000 was a claim against the company (loan or reimbursement); it is not automatically basis in stock unless he exchanged that claim for stock in a bona fide transaction.
The restricted stock purchase agreement dated 9/24/24 (30,000 shares for $30,000) could establish $30,000 basis if (1) it was a real purchase (he paid money or gave property for the stock), and (2) the IRS and courts respect the form. If the $30,000 was satisfied by cancellation of the "due to me" note (debt-for-stock), that can be property in exchange for stock and can give basis, but the substance and timing matter.
Sniff test / red flags: The company was folding mid-2024; the client was told he had no basis; he then produced a 9/24/24 purchase for exactly $30,000 (matching the note) and a 12/24/24 liquidation. So purchase and liquidation are 3 months apart, right before wind-down. That suggests the purpose may have been to create basis (and thus a loss) by converting the note into stock immediately before the stock became worthless, i.e., a step to get a tax loss rather than a bona fide investment. The IRS could attack this under substance-over-form or step-transaction: the economic deal may be "we're writing off the note as uncollectible" (or a bad debt), not "we bought stock and then it went to zero." So whether the client has $30k basis (and thus a $30k loss) is not definitive; it depends on substance, documentation, and intent. You don't have to find a code section that "says no"; facts and substance can support taking the position that the purchase was not a real investment and that basis (or the loss) should not be respected.

Does this qualify for QSBS?

For gain exclusion: The stock would have to be QSBS and held more than 5 years. Here the client "purchased" in 9/24 and the company liquidated 12/24, about 3 months hold. So even if the stock were QSBS, he did not hold more than 5 years, so no QSBS exclusion would apply. And there's no gain anyway (stock worthless), so QSBS doesn't help.
For loss: QSBS doesn't change the character of a loss; § 165(g) (worthless stock) gives capital loss; § 1244 (if the stock qualifies) can give ordinary loss. So "does this qualify for QSBS?" in the loss context is the wrong question; the right questions are basis and § 1244 for ordinary loss.

Ordinary loss under § 1244?

IRC § 1244 allows ordinary loss on small business stock (subject to limits) if, among other things, the stock was issued by a small business corporation for money or property. The 9/24/24 issuance for $30,000 (if treated as debt-for-stock) could potentially be § 1244 stock, but § 1244 has issuance, gross receipts, and other requirements, and the same substance/timing concerns (purchase right before liquidation) can affect whether the issuance is respected for § 1244. A tax professional with the full facts (corporate docs, board minutes, note terms, timing of insolvency) can opine on § 1244 and basis.

What you can tell the client

QSBS does not apply here: it's for excluding gain on sale of stock held more than 5 years; there's no gain and no 5-year hold. So "qualifying for QSBS" doesn't get him an ordinary loss.
Loss: He can only claim a loss if he has basis. The 9/24/24 purchase might give $30k basis if it's treated as a bona fide purchase (e.g., debt-for-stock). But the timing (purchase then liquidation within months) and the match to the "due to me" note support an IRS argument that the transaction lacked substance or was a step to create a loss, so basis (and the loss) could be challenged.
Character: If he has basis, worthless stock = capital loss under § 165(g) unless § 1244 applies (ordinary loss, subject to limits). § 1244 depends on qualification of the stock and substance of the issuance.
Recommendation: Get corporate and tax advice (as you already suggested): board minutes, note terms, why the purchase was done in 9/24, and when the company became insolvent. Document substance if you take basis and loss; consider disclosure (e.g., Form 8275) if you take an aggressive position. Margen can help model the client's tax with and without the loss so you can explain the impact.

Applicable Sections

Federal / IRS

IRC § 1202: QSBS: exclusion of gain on sale of qualified small business stock held more than 5 years. Does not apply to losses; does not create ordinary loss.
IRC § 165(g): Worthless securities: treated as sale or exchange on last day of taxable year; loss is capital loss (short-term or long-term by holding period). Requires basis.
IRC § 1244: Losses on small business stock: can allow ordinary loss (subject to limits) on small business stock issued for money or property by a small business corporation. Separate from QSBS.
Substance over form / step transaction: IRS and courts can recharacterize transactions that lack economic substance or are steps to achieve a tax result (e.g., creating basis right before worthlessness).

Practical Notes

QSBS = gain exclusion for stock held more than 5 years; not relevant for loss or ordinary loss when the company folds and stock is worthless.
Loss requires basis; 9/24/24 purchase for $30k (e.g., debt-for-stock) may give basis, but timing (liquidation 12/24/24) and match to the note support substance/step-transaction challenge.
Worthless stock = capital loss under § 165(g); ordinary loss possible only under § 1244 if stock qualifies.
Document substance and consider disclosure if you take basis and loss; get corporate/tax advice on § 1244 and basis.
Margen can help model the client's tax with and without the loss.

Limitations

This answer does not cover state tax, bad debt deduction as an alternative, or exact § 1244 eligibility. It is not legal or tax advice. For basis, § 1244, and disclosure, consult a tax professional with the full facts. You can use Margen to model the client's position.

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Tax Pro Q: QSBS, Worthless Stock, and a Last-Minute $30k Purchase Before Liquidation (Reddit Q&A)