A recapitalization where stockholders exchange one class of stock for another class of stock of the same corporation is generally treated as a Type E reorganization (Section 368(a)(1)(E)).[9] Section 1202(h)(4)(A) provides that stock received in a Type E reorganization will be “treated as qualified small business stock acquired on the date on which the exchanged stock was acquired,” so the holding period of the original QSBS will include the holding period for the stock received in the exchange.

Under Section 1202(h)(4), stock received in a Type E recapitalization for QSBS should qualify as QSBS if the corporation satisfies all of Section 1202’s eligibility requirements. But what if the issuing corporation fails the $50 Million Test at the time of the recapitalization? This raises the question of whether Section 1202(h)(4)(B) functions to limit the future Section 1202 gain exclusion in a single-corporation transaction. The answer may be found in Section 1202(e)(3), which provides that “rules similar to the rules of section 1244(d)(2) apply for purposes of this section.” Treasury Regulation Section 1.1244(d)-3(c) provides “if, pursuant to a recapitalization described in section 368(a)(1)(E), common stock of a corporation is received by an individual or partnership in exchange for stock of such corporation meeting the requirements of section 1244 stock determinable at the time of the exchange, such common stock shall be treated as meeting such requirements.” Example 1 in those regulations make it clear that the stock that must meet the requirements of Section 1244 determinable at the time of the exchange is the original Section 1244 stock given up in the exchange. A reasonable position would be that “meeting the requirements determinable at the time of the exchange” means that only those eligibility requirements that apply on a continuous basis to outstanding Section 1244 stock (or in the context of Section 1202, QSBS) must be met at the time of exchange in order for the stock received in the exchange to qualify as Section 1244 stock (or QSBS). In the Section 1202 context, this position would mean that in the context of a Type E reorganization (a recapitalization), QSBS treatment for stock received in the exchange would not depend on whether the corporation was continuing to pass the $50 Million Test. Although this result seems reasonable when dealing with a single corporation reorganization, there are currently no tax authorities addressing the issue.