In our last newsletter, in Part I of this article, we discussed how qualified small business stock (“QSBS”) could offer significant tax savings upon the sale of an owner’s interest in a “C” corporation.
However, many business owners instead register their business as a limited liability company (an “LLC”). Some business owners then make a so-called “S” election, and their company is treated as an “S corporation”.
Can LLC and S corporation owners also achieve benefits from QSBS? Yes, under certain circumstances!
Why do business owners favor LLCs and S corporations?
When a solo entrepreneur starts a small business, many accountants (and lawyers) typically recommend that the client set up a pass-through entity such as a limited liability company or a corporation, which makes a so-called “S” election.
To be clear, for many of my clients, that is and remains sound advice given both the annual incremental income tax savings over income tax treatment of “C” corporations and the relative flexibility of LLC governance.
However, when these companies become successful and owners begin to eye an exit or liquidation event, many owners (at least the ones who have heard of QSBS) wonder if they are too late to the gain-exclusion party. The answer is yes, under certain circumstances.
What is the QSBS path forward for the business owner who started with an LLC or S corporation?
Various restructuring strategies may make it possible to essentially create a “new” C corporation to hold and operate the existing business assets.
Put another way, the existing business enterprise can be reorganized as a “C” corporation that issues stock to the prior owners in exchange for the contribution of the existing business assets.
The strategies themselves are somewhat complex and beyond the scope of this overview article. Careful and intensive planning with lawyers and accountants will be required.
But, when done correctly, the end result is that stock issued by the new C corporation in connection with the reorganization of the LLC or S corporation into the new C corporation should qualify as QSBS in the hands of the receiving shareholders.
The five-year “clock” for the QSBS holding period would start on the date of issuance of the stock from the C corporation following he reorganization.
Are there any limitations if I reorganize my existing entity as a C corporation?
Section 1202 is designed to exclude from the QSBS benefits any appreciation of assets prior to the contribution to the qualifying C Corporation.
Therefore, if an LLC created intellectual property assets (such as software, patents, etc.) that had appreciated in value by $5 Million from the date of the LLC’s startup, and then the LLC “converted” to a qualifying C corporation and issued QSBS stock, the first $5 Million of any resulting gain from the later sale of QSBS stock (spread across all applicable shareholders) would not qualify for gain exclusion.
Why? The appreciation occurred “outside” of the C corporation.
Continuing my Widget Corp example from my prior article to help illustrate this point:
- Tim initially starts a small business organized as a limited liability company, Widget LLC. Tim makes an initial contribution of $10,000 to Widget LLC and, in exchange, receives a 50% LLC membership interest.
- Widget LLC creates and develops software now valued at $5,000,000. Tim is kicking himself for not starting the business as a C corp.
- Tim speaks with his attorney, who helps Tim reorganize the Widget LLC business as Widget Corp, a C corporation. Widget LLC contributes all of its assets to Widget Corp in exchange for all of the stock of Widget Corp. Tim now owns 50% of Widget LLC, which in turn owns 100% of the stock of Widget Corp.
- After 7 years, Widget Corp is worth $20 million, and Tim sells his 50% of Widget Corp (by and through Widget LLC) for $10 million.
- However, because Tim started his business as Widget LLC, and the assets of Widget LLC appreciated by $5 million before they were transferred to Widget Corp in a qualifying reorganization, the $5 million pre-contribution gain must be recognized. Tim must take into account his $2.5 million proportionate share of this pre-contribution gain ($5 million multiplied by Tim’s 50% interest).
- Tim (by and through Widget LLC) gets to sell his stock for $10 million, and excludes $7.5 million of capital gain pursuant to QSBS rules. Tim would pay federal capital gains tax on the $2.5 million of gain attributable to the appreciation of assets in Widget LLC prior to the reorganization. Tim is still pretty happy with this outcome.
Additional Thoughts
In QSBS reorganizations, as noted above, the reduction of ultimate gain-exclusion for built-in gains on property contributed to the C corporation, together with the $50 million gross asset value test and the 5-year holding requirement for QSBS stock before sale, all become critical to effective planning.
Business owners should review their options with their tax advisors well in advance of a potential exit. In addition, QSBS reorganization transactions may be subject to greater IRS scrutiny and must therefore be carefully structured and documented to support QSBS qualification.
And One Important Caveat
As of the drafting of this article, Congress is considering amendments to Section 1202 in connection with the One Big Beautiful Bill Act.
There are significant differences between the House version of the Bill and the Senate version of the Bill, which, if the Bill is passed, will be reconciled in Committee.
While QSBS will continue to be available to business owners, no matter the outcome of Congressional debate, we are continuing to monitor the OBBBA for any changes to the QSBS rules.
Are you interested in learning more about QSBS? Do you want to learn more if the One Big Beautiful Bill Act passes about how QSBS laws and deductions might have changed? Contact Tim Canney, chair of the Business & Tax Group at Bulman Dunie, at (301) 656-1177 x331 or tcanney@bulmandunie.com
