By: Steven Masur (with research and writing assistance from Maria Samson)
A great many entrepreneurs who believe they may one day sell their companies have been calling to ask whether they need to close their LLC and open a corporation in order to reduce or avoid capital gains tax on the sale of their company under Section 1202, QSBS (defined below), a new provision of the IRS Tax Code (the "Code"). Here’s the answer.
Section 1202 of the Code ("Section 1202"), amended in 2017, now provides tax breaks for capital gains incurred from the sale or exchange of eligible small business, C corporation stocks. Specifically, owning qualified small business stock ("QSBS") may excuse one from paying hefty federal capital gains tax. Congress passed Section 1202 to create incentives for individuals to either start businesses or invest in them. Because QSBS only applies to C corporations, it may make sense to disband an existing corporate structure to form a new C corporation. QSBS allows non-corporate investors to exclude up to 100% of federal capital gains tax incurred from selling their stake in the business. More people ought to know about QSBS due to recent changes in the regulation and the potential benefits of applying for it.
To qualify for the QSBS exemption, first, the investor must be non-corporate. They must be a natural person, not a formed entity, and they must receive the QSBS at the time of issuance. This means the company must give the QSBS directly to the investor when they issue stock, not at any later date or through a resale. The total amount of the gain excludable depends on when the QSBS was issued. Importantly, the issuing company must be a C corporation, not a limited liability company ("LLC") or a partnership. This is important for already established companies to contemplate if they wish to take advantage of QSBS. While there are advantages to having an LLC or other corporate structure, such as avoiding double taxation, benefiting from QSBS is not one of them.
The company must also meet both the gross assets requirement and the active business requirement. To meet the gross assets test, the aggregate gross assets cannot exceed $50 million at the time of issuance. The value of the investor’s stake may increase later on, but it cannot be more than $50 million when the investor receives it. Moreover, to meet the active business test, the business must use at least 80% of its assets engaging in a "qualified trade or business." The Code defines this by exemption. It is defined as any business that does not provide services in the fields of health, law, engineering, accounting, etc. QSBS is not available for any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. Lastly, to get the tax benefits, one must hold on to the stock of the corporation for a period of 5 years. After the 5-year period, the investor may sell the QSBS tax-free.
Seemingly, it may be in an entrepreneur’s interest to consider whether they could benefit from QSBS and if they should restructure their current structure to apply for it. For an LLC, conversion to a C corporation could allow non-corporate partners or investors to qualify for QSBS. They could use the fair market value of the LLC interests at the time of conversion to calculate for the potential tax exclusion. The eligible gain exclusion is determined either by (i) the greater of $10 million or (ii) 10 times the original basis amount. For instance, if an investor’s LLC interest is valued at $2 million when they convert the LLC to a C corporation, the maximum QSBS gain exclusion amount can jump to $20 million if they hold the stock for 5 years.
Ultimately, if a business owner has any plans to later sell the business, planning for QSBS wouldn’t hurt. An investor owning QSBS could see the price of that stock eventually skyrocket and they can profit from that investment completely tax-free. For this reason, it may be worth dissolving an existing LLC to form a C corporation for QSBS.