Section 351 & QSBS: Establishing the FMV Basis Floor at C-Corporation Conversion

Introduction

When you move an LLC, a partnership, or another business into a C corp under Section 351, the fair market value (FMV) of that business on the day you convert can set a special basis floor. This floor matters for Qualified Small Business Stock (QSBS) under Section 1202(i). It can change both your gain exclusion limit and how the company scores on the gross-assets test. That makes the day-of-conversion value one of the most critical numbers in QSBS planning.

Why This Matters for Founders Right Now

Moving a business into a C corp seems simple. You hand over the LLC’s assets. The new corp gives you stock. If you meet the rules of Section 351, no tax hits right away.

But most founders then jump to the bigger question: can these new shares count as QSBS under Section 1202? That question gets a lot of focus. A related one gets far less: how much was the business worth on the exact day of the switch?

That single number can shift your tax bill by millions.

Since the One Big Beautiful Bill Act (OBBBA) became law on July 4, 2025, the stakes are even higher. The new law brought a tiered gain exclusion (50% at 3 years, 75% at 4, 100% at 5), raised the per-issuer cap from $10 million to $15 million, and bumped the gross-assets ceiling from $50 million to $75 million. Each of these changes makes the FMV on conversion day more important than ever.

At Transaction Capital LLC, we help founders, CFOs, and tax advisors get this number right. Our team holds ABV®, ASA, CVA® and MRICS credentials. We have done more than 2,500 valuations across 50+ industries. We deliver audit-ready reports in 3 to 5 business days with flat fees starting at $500.

Key Takeaways

• A Section 351 exchange lets you move a business into a C corp without paying tax on the gain right away.
  
• The stock you get may count as QSBS if all Section 1202 rules are met on their own.
  
• Under Section 1202(i), your stock basis for QSBS is treated as at least equal to the FMV of what you put in. This is the QSBS FMV basis floor.
  
• After July 4, 2025, the OBBBA gives you a phased exclusion: 50% at 3 years, 75% at 4 years, 100% at 5 years. The cap is now $15 million (it rises with inflation after 2026).
  
• The gross-assets ceiling went up from $50 million to $75 million for post-OBBBA stock. This gives more room but still needs careful FMV review.
  
• A higher FMV helps your basis floor but can push the company closer to the gross-assets limit. These two effects pull in opposite directions.
  
• A valuation done at the time of conversion is much easier to defend than one put together years later at exit.
  
• The OBBBA got rid of the AMT add-back for gain excluded under the new tiered rules. This removes a long-standing worry for founders.
  

What Is Section 351 Conversion?

Section 351 is one of the core tax-free exchange rules in the tax code. It says that no gain or loss is taxed when you hand over property to a new corp in trade for its stock. You must own at least 80% of the corp right after the swap.

The idea is simple. If you keep control of the same business in a new legal wrapper, that change alone should not trigger a tax bill.

Example. A founder runs an LLC with a tax basis of $400,000 and an FMV of $2 million. There are no big debts. She puts the LLC’s assets into a new C corp and gets all the stock. If Section 351 applies, she does not owe tax on the $1.6 million of built-in gain at that point.

But tax-free does not mean basis-free. Under the basic rules, your stock basis carries over from what you put in (Section 358). The corp’s asset basis also carries over (Section 362). Section 1202 then adds its own special rule on top of this for QSBS.

What Is Qualified Small Business Stock (QSBS)?

QSBS is stock that meets all the tests under Section 1202. If it does, you may be able to cut out some or all of the gain when you sell.

How the Exclusion Works After the OBBBA (Stock Issued After July 4, 2025)

The OBBBA brought a tiered system tied to how long you hold the stock:

• Hold 3+ years: Exclude 50% of gain.
  
• Hold 4+ years: Exclude 75% of gain.
  
• Hold 5+ years: Exclude 100% of gain.
  

The most you can exclude per company went up from $10 million to $15 million. This number will rise with inflation for tax years starting after 2026. The backup limit of 10 times your basis stays the same.

The gross-assets test went from $50 million to $75 million for stock issued after July 4, 2025. This cap will also rise with inflation for stock issued after 2026.

One more big change: the OBBBA got rid of the AMT hit on excluded QSBS gain under the new rules. Before this, some founders held off on early exits because the AMT ate into the benefit.

Core QSBS Tests

To count as QSBS, the stock must meet these tests:

• It must be stock of a U.S. C corp.
  
• You must get it at first issue, in trade for money, property, or some services.
  
• The corp must pass the gross-assets test when it hands out the stock.
  
• The corp must run an active business the whole time you hold it.
  
• You must hold it long enough for an exclusion to kick in.
  

The first-issue rule is the key link to LLC-to-C-corp deals. A proper Section 351 swap can give you stock that counts as first-issue. That is where Section 351 and Section 1202 overlap.

Why Do LLC-to-C-Corp Conversions Matter for QSBS?

Most startups do not begin as C corps. Founders often start with an LLC or another pass-through setup. They switch to a C corp later, when they need VC funding, stock option plans, or QSBS benefits.

If done right, this switch can happen under Section 351 with no tax hit. The new stock may count as first-issue QSBS if the corp meets all the Section 1202 tests.

The date of the swap is critical. It is treated as the date you got the stock for QSBS purposes. Time you spent running the LLC does not count toward the QSBS holding period. This can shift your exit timeline by years.

Under the OBBBA, timing matters even more. The old rules needed five full years before any benefit kicked in. Now, stock issued after July 4, 2025 starts earning a partial exclusion at just three years. A founder who converts in mid-2026 and holds for three years can claim 50% on the gain at exit. That is a strong reason to convert and get your FMV on record early.

What Is Section 1202(i) FMV Basis Floor?

When you put property (not cash or stock) into a corp and get stock back, Section 1202(i)(1) sets a special rule. For QSBS math, your stock basis is treated as at least equal to the FMV of what you put in. This is the FMV basis floor.

Example. A founder built a software business as an LLC. Right before the switch, the tax basis of the assets is $300,000. The FMV is $3 million. She puts it all into a new C corp under Section 351.

For normal tax math, her stock basis may stay near $300,000 (the carryover rule). But for QSBS math, the basis cannot be less than $3 million, the FMV of what she put in. That number drives her future gain exclusion.

This is why the day-of-conversion valuation needs real focus.

Does the FMV Basis Floor Raise the Corp’s Asset Basis?

No, not in most cases. Section 362 says the corp gets the same basis you had in the assets, plus any gain you paid tax on. The Section 1202(i) floor only changes your stock basis for QSBS purposes. It does not touch the corp’s asset basis.

With the numbers above, the corp’s basis in the assets stays near $300,000. Your QSBS stock basis may sit at $3 million. These are two different numbers for two different tax rules. A good valuation report should spell out the gap clearly.

How Does FMV Change the QSBS 10x Basis Limit?

Section 1202 caps the gain you can exclude at the higher of a dollar amount or 10 times your basis in the stock you sell. Since Section 1202(i) can set your basis at the FMV of what you put in, a solid FMV can push this cap way up.

Example. Your LLC has a tax basis of $200,000 but is worth $5 million on the day you convert. If the FMV floor applies:

• 10x on the old basis: 10 x $200,000 = $2 million.
  
• 10x on the FMV floor: 10 x $5,000,000 = $50 million.
  
• Dollar cap (post-OBBBA): $15 million.
  

You get the higher number. With the FMV floor, the cap is $50 million. Without it, the cap is just $15 million (since $2 million is less than the dollar cap). That is a huge gap.

To lock in this benefit, you need a valuation that can stand up to review. The number must rest on real data: the company’s finances, market evidence, and deals done at the time of conversion.

How Does FMV Affect the QSBS Gross-Assets Test?

For stock issued after July 4, 2025, the corp must have no more than $75 million in gross assets right before and after it gives out the stock. For this test, assets you put in are counted at FMV, not at old tax basis. So a high FMV can push the corp over the line.

Example. A business has a tax basis of $4 million but an FMV of $82 million at the time you put it in. The tax basis alone would leave lots of room under $75 million. But the gross-assets rule uses FMV. At $82 million, the stock may not pass the test.

The Push-Pull Between Basis Floor and Gross-Assets Test

Here is the twist. A higher FMV helps your basis floor (bigger 10x cap). But that same higher FMV can hurt the gross-assets test (less room under $75 million). These two effects work against each other.

This is why the appraiser should not be told to hit a target number. The job is to find the true FMV. After that, tax counsel can sort out how the number plays out under both rules.

Pre-OBBBA vs. Post-OBBBA QSBS Rules at a Glance

Why Get an Independent Valuation at the Time of Conversion?

A valuation done on the day of conversion captures the company’s finances, market conditions, and methods while the data is fresh. Trying to rebuild this picture years later, after the company has grown or changed hands, is much harder. It may also produce a weaker record.

Example. A company converts to a C corp in 2026 and sells for $80 million in 2033. The founder wants to use a 2026 FMV of $6 million. But the only proof is a pitch deck, a spreadsheet, and an email that says “worth about $6 million.” That is not enough to back a claim of that size.

A look-back valuation is an option. But the appraiser must sort out what was known in 2026 from what happened later. A 2028 funding round, for example, cannot be treated as proof of 2026 value. The appraiser must also piece together old financial statements, forecasts, and market data.

Getting the valuation right at the start cuts the risk of a weak record when the stakes go up at exit.

Do Section 351 Control Rules Still Apply?

Yes. A valuation does not prove that a deal meets Section 351. You (or your group of transferors) must own at least 80% of the new corp’s voting power and 80% of every other class of stock right after the swap. This is the Section 368(c) control test.

The check gets harder when:

• More than one founder puts in assets.
  
• Investors put in cash at the same time.
  
• Employees get stock for work, not property.
  
• Ownership shifts soon after the company is formed.
  
• The conversion and a funding round happen together.
  

If you bundle the conversion with a priced round, watch out. Treasury rules say that property of very small value put in just to help others pass the control test may be ignored. So it is safer to close the conversion first, let it settle, and then close the funding round as a separate deal.

Tax counsel should map out the deal before anyone counts on Section 351 treatment. The appraiser’s job is to find the value of the property or business. The appraiser does not say whether the legal rules are met.

What Valuation Methods Work for Section 351/QSBS?

No law says you must use one formula. A solid valuation usually looks at three methods. The best pick depends on the type of business, its stage, and how good the financial data is.

Income Approach

A discounted cash flow (DCF) model builds up value from projected revenue, costs, EBITDA, capital spending, and free cash flow. These numbers are then discounted at a rate that reflects the risk of hitting the targets. For early-stage and fast-growing companies, the appraiser must test the forecasts rather than just accept them.

Market Approach

This method looks at what similar companies sell for. Sources include public company data, private deals, recent funding rounds, and industry ratios like EV/Revenue, EV/ARR, or EV/EBITDA. The appraiser must adjust for differences in size, growth rate, profit margins, and risk.

Asset Approach

This works best for companies with lots of hard assets, holding companies, or firms with little earnings history. It adds up the current values of all assets and subtracts all debts.

The work should line up with IRS Revenue Ruling 59-60. That ruling says to look at the business’s nature and history, the economic outlook, book value, earning power, dividend record, and sales of similar stock.

Can a Recent Funding Round Set the Conversion Date FMV?

A recent arm’s-length funding round can serve as useful evidence. But it does not set the FMV by itself. The appraiser must dig into the terms of the deal before using the price.

Key questions: What class of stock was issued? What rights came with it (liquidation preferences, conversion rights, participation)? How big was the round? When did it close? Was it a real arm’s-length deal?

A preferred-stock round at a $20 million post-money value does not mean the operating business or the common stock is worth $20 million. Enterprise value, total equity value, and the value of the property you put in are three different things. Do not mix them up.

Can a 409A Valuation Stand in for a Section 351/QSBS Valuation?

Not on its own. A 409A valuation usually prices common stock on a minority, non-marketable basis. A Section 351/QSBS valuation may need the FMV of the whole business, specific assets, or a different type of interest. The numbers can be very different.

Enterprise value, total equity value, preferred-stock value, and common-stock value after a marketability discount are all separate concepts. The valuation must match the exact tax question you are trying to answer.

Marketability discounts need extra care. Using a discount to lower a gross-assets number may be wrong if the test is really about the value of the whole operating business, not a tiny minority stake.

What Should a Section 351/QSBS Valuation Report Cover?

A strong report should clearly state the date, define what is being valued, explain the purpose, walk through the data and methods, and land on a number that makes sense to someone who was not in the room.

At a minimum, the report should cover:

1. The valuation date that matches the actual conversion day.
   
2. The exact thing being valued (business, LLC interest, or specific assets).
   
3. Why the valuation is being done (its tie to Section 351 and Section 1202).
   
4. The standard of value (usually FMV).
   
5. Past and current financial results.
   
6. The full cap table, including options, warrants, SAFEs, and convertible notes.
   
7. The industry and market picture at the time.
   
8. Which methods were looked at, which were used, and what was assumed.
   
9. A clear dollar figure as of the valuation date.
   

What Records Should You Keep at Conversion?

Keep these records safe from day one:

• Section 351 deal papers and contribution agreements.
  
• Board sign-offs and corporate resolutions.
  
• Cap tables showing who owned what before and after.
  
• Stock certificates and issuance records.
  
• Tax-basis schedules for every asset put in.
  
• Financial statements (audited or reviewed if you have them).
  
• The pass-through entity’s tax returns.
  
• Debt and liability schedules.
  
• IP records and assignment agreements.
  
• Funding papers (term sheets, SAFEs, convertible notes).
  
• The independent valuation report.
  

An exit may come many years after the conversion. If you wait, records get lost, people leave, and systems change. Saving these files now cuts the risk of a bad record when the dollars are on the line.

Section 1045 Rollover: Another Piece of the Puzzle

Section 1045 lets you put off the tax on a QSBS sale by rolling the money into new QSBS within 60 days. The new stock picks up where the old one left off on the holding clock.

For founders near a conversion, this adds a planning option. If you sell QSBS before the five-year mark, a Section 1045 rollover can keep the door open for a full 100% exclusion on the next stock. Under the OBBBA, you must have held the first stock for more than six months before the sale for this to work.

This link between Section 351, Section 1202, and Section 1045 calls for teamwork among tax counsel, the appraiser, and the company’s finance team.

Common Mistakes Founders Make

• Counting LLC time toward the QSBS hold. It does not count. Under Section 1202(i), the clock starts on the day of the exchange.
  
• Thinking the corp gets a stepped-up basis. It does not. Section 362 gives a carryover basis.
  
• Using book value as FMV. Book value and FMV are not the same thing.
  
• Assuming a higher FMV is always better. A higher FMV helps your basis floor but can push you over the gross-assets ceiling.
  
• Waiting until exit to get a valuation. A look-back valuation is harder and weaker.
  
• Treating a 409A report as a Section 351/QSBS report. They value different things at different levels.
  
• Telling the appraiser to hit a target number. This kills the report’s credibility.
  
• Closing the conversion and a funding round at the same time. This can break the 80% control rule.
  
• Not saving records at conversion. Papers get lost when people and systems change.
  
• Ignoring state QSBS rules. Not every state follows the federal Section 1202 exclusion.
  

Final Thoughts

The conversion date deserves real attention in QSBS planning. Section 351 lets you move a business into a corp with no tax hit. Section 1202 then uses a special FMV-based rule that can shape your future stock basis, gain exclusion cap, and gross-assets outcome. Each of these is tied to a single number on a single date.

The OBBBA has raised the stakes. A $15 million cap, a $75 million gross-assets ceiling, and a tiered exclusion that starts at three years all make the day-of-conversion FMV more valuable than ever. Founders who document this value at the right time are better set to defend their QSBS claim at exit.

The goal is not to push the number up or down. It is to find a solid FMV for the right property, on the right date, backed by real evidence. Waiting until exit to do this work only makes it harder and riskier.

Frequently Asked Questions

1. Can stock from a Section 351 conversion count as QSBS?

It can. Stock issued by a U.S. C corp in trade for property may pass the first-issue test under Section 1202. But every other QSBS rule must also be met on its own. Talk to tax counsel about your specific deal.

2. What is the Section 1202(i) FMV basis floor?

When you put property (not cash or stock) into a corp and get stock back, your QSBS basis is treated as at least equal to the FMV of that property on the swap date. This is the FMV basis floor.

3. Does the FMV floor raise the corp’s asset basis?

No. Section 362 gives the corp a carryover basis from you, plus any gain you paid tax on. The Section 1202(i) rule only affects your stock basis for QSBS math.

4. How does FMV change the 10x basis cap?

Section 1202(i) can set your basis at the FMV of what you put in. A higher, solid FMV raises the number used in the 10x cap, which can boost the total gain you can exclude.

5. How does FMV affect the gross-assets test?

Assets you put in count at FMV for the gross-assets test. A higher FMV can push the corp closer to, or past, the $75 million ceiling.

6. Does LLC holding time count toward the QSBS hold?

No. Under Section 1202(i), stock you get in trade for property is treated as gotten on the day of the trade. Years of LLC work do not add to the QSBS hold.

7. Can a 409A valuation work for Section 351/QSBS?

Not by default. A 409A report usually prices common stock on a minority, non-marketable basis. A Section 351/QSBS analysis may need the FMV of the whole business or a different kind of interest.

8. What is the current gross-assets limit for QSBS?

For stock issued after July 4, 2025, the limit is $75 million. This is up from the old $50 million. It will rise with inflation for stock issued after 2026.

9. What did the OBBBA change about QSBS?

Three big changes: a tiered exclusion (50% at 3 years, 75% at 4, 100% at 5), a higher cap ($15 million, up from $10 million), and a higher gross-assets ceiling ($75 million, up from $50 million). Both the cap and ceiling will rise with inflation.

10. Did the OBBBA fix the AMT problem for QSBS?

Yes. The OBBBA removed the AMT add-back for gain excluded under the new tiered rules for post-OBBBA QSBS. Founders no longer face AMT leakage on these exclusions.

About Transaction Capital LLC

Transaction Capital LLC is an independent valuation firm. We focus on business, equity, and intangible-asset valuations for tax, financial reporting, and deal purposes. Our work includes Section 351 and QSBS/Section 1202 valuations, 409A valuations, gift and estate tax valuations, ASC 805 purchase price allocations, and IP valuations. Our team holds ABV®, ASA, CVA® and MRICS credentials and has done more than 2,500 valuations across 50+ industries.

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