Insights

Converting an LLC or S Corporation to a QSBS C Corporation
to Avoid Federal Taxes on Gain on Sale of Business

There is a way for qualifying LLCs and S corporations to convert to a C corporation to take advantage of the lucrative qualified small business stock (“QSBS”) exclusion under IRC Sec. 1202. This can provide the owners of these entities with significant excludable gain in the right circumstances but can be detrimental in the wrong fact pattern.

A Discussion of the QSBS Exclusion

Section 1202 of the Internal Revenue Code allows non-corporate taxpayers, including S corporations and LLCs, to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment. Unlike in prior years, this creates possible opportunities for non-corporate taxpayers who dispose of a QSBS in a taxable transaction to potentially exclude the entire gain for federal tax purposes.  Assuming all applicable requirements are met, the 0 percent federal income tax rate would apply to gains from sales of QSBS acquired at any time after September 27, 2010.

Also, the treatment of no portion of the excluded gain is a preference item for AMT purposes. The capital gains that are exempt from tax under this section are also exempt from the 3.8% net investment income (NII) tax applied to most investment income.

Qualified small business stock (QSBS) is the stock—or shares—of a qualified small business (QSB), as defined by the Internal Revenue Code. A qualified small business is an active domestic C Corporation whose gross assets, valued at original cost, do not exceed $50 million on and immediately after its stock issuance.

Several requirements must be satisfied before those benefits can be realized, and even if those requirements are met, there are important limitations on the amount of gain that can qualify for the 0 percent rate.  These requirements and limitations are further discussed below.

General Requirements

The general requirements for qualifying for the 0 percent federal tax rate on gains from the sale of QSBS include the following:

• The investor must not be a corporation.
• The investor must have acquired the stock at its original issue and not on the secondary market.
• The investor must have purchased the stock with cash or property or accepted it as payment for a service.
• The investor must have held the stock for at least five years.
• At least 80% of the issuing corporation’s assets must be used in the operations of one or more of its qualified trades or businesses.
• The aggregate gross assets of the corporation that issued the stock cannot have exceeded $50 million at any time before (and including the time immediately after) the issuance of the stock to the taxpayer.
• During substantially all of the taxpayer’s holding period of the stock, at least 80 percent of the issuing corporation’s assets must be used by the corporation in the active conduct of one or more qualified trades or businesses.

The Internal Revenue Code (IRC) Section 1202 defines a qualified small business (QSB), and only certain types of companies are eligible. For example, companies in the hospitality industry, personal services, the financial sector, farming, and mining are not eligible. Those that are eligible include companies in the technology, retail, wholesale, and manufacturing sectors.

Example of Qualified Small Business Stock (QSBS) Taxation

If someone invested $1.5 million in a tech startup on October 1, 2010, and held that investment for five years, they could sell their QSBS for up to $16.5 million (10 x their original investment of $1.5 million) + $1.5 million, without owing capital gains tax. Once they deduct their initial investment, they have a $15 million capital gain, none of which is taxable on their federal income tax.

Similarly, an investor who put $500,000 into the same tech startup would be able to sell their shares for up to $10.5 million ($10 million + $500,000), with no tax on their capital gain of $10 million. However, if the investor’s proceeds from the sale totalled $20 million, a 28% capital gains tax would be applied to the additional $10 million gain.

What if an S corporation or LLC wants to benefit from the potential tax savings under Section 1202? With the reduced corporate tax rate of 21%, converting to a C corporation is becoming more attractive. Here are some of the methodologies and risks in converting a pass-through entity to a QSBS:

Converting a Limited Liability Company

For a limited liability company (“LLC”) taxable as a partnership, the LLC can simply make a check-the-box (“CTB”) election on Form 8832 to be treated as a corporation for tax purposes. The reason this works so well is because CTB is tantamount to an issuance of shares, making the LLC a qualified corporate entity. Another option to accomplish the conversion would be via a statutory conversion under state law.

Converting an S Corporation

Qualifying an S corporation for QSBS is a little more complicated. It’s nothing akin to a CTB election for LLCs, as terminating an S corporation is not deemed to be a new issuance of shares.

Since an S corporation cannot simply convert to a C corporation and satisfy the original issuance requirement of IRC Sec. 1202, an F-reorganization under IRC Sec. 368(a)(1)(F) should be considered as a possible option. For this instance, it can be effectuated by:

1. Creating a new S corporation (“NewCo”) and shareholders contribute their stock of the old S Corporation (“OldCo”) to NewCo in exchange for stock.
2. OldCo makes a qualified S corporation subsidiary (“QSub”) election.
3. Once the F-reorganization is in place, OldCo is converted into a single member LLC (“SMLLC), resulting in NewCo owning the SMLLC.
4. Create a new C corporation and contribute the SMLLC interests to the corporation in exchange for QSB stock. This is treated as a qualifying transfer of property under IRC Sec. 1202. Many will find this administratively easier than contributing the assets, as it avoids retitling of the assets.

The result is the S corporation owning 100% of the QSBS, and its shareholders can qualify for the exclusion. It’s important to note that a valid business purpose for the restructuring should be established, other than just to qualify for QSBS, to avoid the IRS contesting the validity of the transaction, and ultimately the intended tax benefit.

Important Considerations in a Pass-Through Entity Conversion

Whether the conversion is by an LLC or S corporation, the $50 million gross asset test must be considered prior to conversion. Since this is essentially a transfer of property, under IRC Sec. 1202(d)(2)(B) the basis of the assets for the purposes of determining the $50 million test would be equal to their fair market value (“FMV”) at the time of conversion – a notable distinction. While it may seem like a disadvantage for the gross asset test, it can be good news on the flip side as no less than the FMV is now considered in determining the 10x basis limitation, which can increase the amount of excluded gain.
One other notable consideration is that any built-in appreciation at time of conversion will not qualify for the exclusion since it was earned prior to QSBS status. Only post-conversion appreciation earned as a QSBS would be eligible.

Here are two examples of this:

Example 1

• In 2012, A contributes $500,000 to LLC for 50 units.
• A few years later the LLC checks the box and converts to C corporation status when the value of those units are $7 million (and the LLC has no liabilities).
• Five years later, the 50 units are sold for $70 million, resulting in $69.5 million of realized gain (the taxpayers federal income tax basis of the stock was $500,000).
• A’s exclusion under IRC Sec. 1202 is limited to $63 million ($70 million proceeds less $7 million value at time of conversion), resulting in taxable gain of $6.5 million.
• A’s tax bill will be based on the long-term capital gain (“LTCG”) rates on the $6.5 million gain.

Example 2

• Similar facts as above, but the units were sold for $12 million instead of $70 million, resulting in $11.5 million of realized gain.
• A’s exclusion under IRC Sec. 1202 would be limited to $5 million of gain ($12 million of proceeds less $7 million value at time of conversion), resulting in taxable gain of $6.5 million.
• The $6.5 million would be taxed at LTCG rates, same as in Example 1.
• In this case, if the conversion would have occurred earlier at a $500,000 value, the excludable gain under IRC Sec. 1202 would be $10 million (and up to a $500,000 tax basis recovery).

Final Considerations for QSBS Conversion
The decision to convert a pass-through entity to a C corporation to qualify for QSBS status must be approached with careful consideration and a bit of foresight. Key factors would be tax rates, single versus double taxation, annual taxable activity, and perhaps most importantly, exit strategy.

Conversion to QSBS for a pass-through entity might make sense for owners that plan to hold the stock for longer than five years and ultimately sell the stock. It has declining benefits in the other scenarios. It can be detrimental, versus remaining a pass-through, if the exit occurs prior to five years. Taxpayers need to consider future possible scenarios before looking to convert their pass-through entities and be mindful of the potential detrimental tax impacts of certain exits.  It’s imperative for taxpayers to carefully analyse each situation and consult with their advisors before implementing such a conversion, to maximize tax savings.

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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.