Insights

Converting an S Corporation or LLC into a Qualified
Small Business for IRS Code Section 1202

IRC Section 1202, enacted in 1993, incentivizes investment in small businesses by allowing non-corporate taxpayers to exclude capital gains from the sale of QSBS held for more than five years. For stock acquired after September 27, 2010, the exclusion can be up to 100% of the gain, capped at the greater of $10 million or 10 times the adjusted basis of the stock sold per shareholder, per corporation. To qualify as QSBS, the stock must meet several requirements:

• C Corporation Requirement: The stock must be issued by a domestic C corporation.
• Gross Assets Test: The corporation’s aggregate gross assets must not exceed $50 million before and immediately after the stock issuance.
• Active Business Requirement: At least 80% of the corporation’s assets (by value) must be used in a qualified trade or business during substantially all of the shareholder’s holding period. Excluded businesses include those in hospitality, personal services, financial services, farming, mining, or where the principal asset is the reputation or skill of employees.
• Original Issuance: The stock must be acquired directly from the corporation at its original issuance in exchange for money, property (other than stock), or services.
• Holding Period: The stock must be held for more than five years to qualify for the full exclusion, though partial exclusions (50% or 75%) apply for earlier acquisition dates.

S corporations and LLCs, as pass-through entities, cannot directly issue QSBS. However, they can be restructured to meet these requirements through specific conversion methods. Below, we outline the processes for converting both entity types into a QSB.

Converting an LLC into a Qualified Small Business

LLCs, typically taxed as partnerships or disregarded entities, have several straightforward options to convert to a C corporation and qualify as a QSB. The conversion process must ensure that the resulting stock meets the original issuance requirement and other QSBS criteria. Here are the primary methods:

1. Check-the-Box Election

The simplest method for an LLC to become a C corporation is to file a “check-the-box” election using IRS Form 8832, electing to be treated as a corporation for federal tax purposes. This election is effective as a deemed issuance of shares, making the LLC a qualified corporate entity for QSBS purposes. Key steps include:

• File Form 8832: The LLC submits Form 8832 to elect corporate tax treatment, effective on a specified date. This is treated as a tax-free Section 351 exchange, where LLC members receive C corporation stock in exchange for their membership interests.
• Verify QSBS Eligibility: Ensure the LLC’s gross assets do not exceed $50 million before and immediately after the election, and that at least 80% of assets are used in a qualified trade or business (e.g., technology, retail, wholesale, or manufacturing).
• Holding Period: The QSBS holding period begins on the date of the check-the-box election, not the LLC’s formation date.

Advantages: This method is administratively simple, avoids the need to retitle assets, and preserves the LLC’s existing Employer Identification Number (EIN).

Considerations: Any built-in appreciation in the LLC’s assets at the time of conversion will not qualify for the QSBS exclusion, as only post-conversion appreciation is eligible. The fair market value (FMV) of assets at conversion is used for the $50 million gross assets test, which can impact eligibility if the LLC’s value is high.

2. Statutory Conversion

An LLC can convert to a C corporation under state law through a statutory conversion, where the LLC legally transforms into a corporation. This process varies by state but typically involves:

• State Filing: File a certificate of conversion with the state’s business registry, converting the LLC to a C corporation. This results in the issuance of stock to former LLC members.
• QSBS Compliance: Confirm that the corporation meets the $50 million gross assets test and the active business requirement. The stock issued during the conversion qualifies as original issuance under IRC Section 1202.
• Holding Period: The QSBS holding period begins on the conversion date.

Advantages: Statutory conversion is a clean transition to C corporation status, often avoiding complex asset transfers.

Considerations: State-specific requirements and fees apply, and the process may involve updating contracts, licenses, or permits to reflect the new corporate entity.

3. Incorporation via Asset Contribution

An LLC can incorporate by contributing its assets to a newly formed C corporation in exchange for stock, qualifying as a tax-free Section 351 exchange. Steps include:

• Form a New C Corporation: Establish a new domestic C corporation.
• Contribute Assets: The LLC transfers its assets (and liabilities) to the C corporation in exchange for stock, which is distributed to LLC members.
• QSBS Eligibility: Ensure the corporation’s gross assets are under $50 million immediately after the contribution, and that the business qualifies as a QSB. The stock received by LLC members qualifies as QSBS if all requirements are met.

Advantages: This method allows flexibility in structuring the transaction and can preserve QSBS eligibility for the new stock.

Considerations: Asset transfers may require retitling contracts, licenses, or permits, which can be administratively burdensome. The FMV of contributed assets is used for the gross assets test, and pre-contribution appreciation does not qualify for the QSBS exclusion.

Converting an S Corporation into a Qualified Small Business

Converting an S corporation to a QSB is more complex than for an LLC, as simply terminating the S election does not satisfy the original issuance requirement of IRC Section 1202. The stock of an S corporation that becomes a C corporation retains its character as non-QSBS stock. To qualify, S corporation shareholders must restructure the entity to receive new C corporation stock. The most common method is an F-reorganization under IRC Section 368(a)(1)(F). Here’s how it works:

F-Reorganization Process

An F-reorganization restructures the S corporation to create a new C corporation that issues QSBS. The steps are as follows:

1. Form a New S Corporation (Holdco): Organize a new S corporation, referred to as “Holdco.”
2. Contribute Old S Corporation Stock: Shareholders of the existing S corporation (“Oldco”) contribute their stock to Holdco in exchange for Holdco stock. This is a tax-free exchange under IRC Section 368(a)(1)(F).
3. Convert Oldco to a Single-Member LLC (SMLLC): File Form 8869 to make a Qualified Subchapter S Subsidiary (QSub) election for Oldco, followed by converting Oldco into an SMLLC, which is disregarded for tax purposes. Oldco retains its historic EIN.
4. Form a New C Corporation (Newco): Organize a new domestic C corporation.
5. Contribute SMLLC Interests: Holdco contributes the SMLLC interests (formerly Oldco) to Newco in exchange for C corporation stock. This is treated as a tax-free Section 351 exchange, and the stock received by Holdco qualifies as QSBS if all Section 1202 requirements are met.
6. QSBS Eligibility Check: Verify that Newco’s gross assets do not exceed $50 million before and immediately after the stock issuance, and that at least 80% of its assets are used in a qualified trade or business.

Resulting Structure: The structure becomes a three-tiered arrangement: an S corporation (Holdco) owns a C corporation (Newco), which owns an SMLLC (formerly Oldco). The stock issued by Newco to Holdco can qualify as QSBS, allowing S corporation shareholders to potentially claim the Section 1202 exclusion upon sale.

Advantages: This method avoids the need to retitle assets, as the SMLLC retains Oldco’s contracts, licenses, and EIN. It allows S corporation shareholders to access QSBS benefits while maintaining pass-through taxation for other income.

Considerations: The F-reorganization requires careful planning to ensure compliance with IRS rules. A valid business purpose (beyond tax avoidance) must be documented to withstand IRS scrutiny. The FMV of assets at the time of contribution to Newco is used for the $50 million gross assets test, and only post-reorganization appreciation qualifies for the QSBS exclusion.

Alternative: Asset Contribution to a New C Corporation

An S corporation can transfer its assets to a newly formed C corporation in exchange for stock, qualifying as a Section 351 exchange. Steps include:

• Form a New C Corporation: Establish a new domestic C corporation.
• Contribute Assets: The S corporation transfers its assets and liabilities to the C corporation in exchange for stock, which is distributed to S corporation shareholders.
• QSBS Eligibility: Ensure the C corporation meets the $50 million gross assets test and the active business requirement. The stock received qualifies as QSBS if all conditions are met.

Advantages: This method directly creates QSBS-eligible stock for shareholders.

Considerations: Asset transfers can be complex, requiring retitling of contracts, licenses, and permits. Pre-contribution appreciation does not qualify for the QSBS exclusion, and the process may trigger consent requirements for certain assets.

Key Considerations for Both Conversions

1. Gross Assets Test

The $50 million gross assets test is critical. Assets are valued at their FMV at the time of conversion or contribution, which can be a challenge for LLCs or S corporations with significant appreciated assets. For example, an LLC with a low tax basis but high FMV may approach or exceed the $50 million threshold, disqualifying it from issuing QSBS.

2. Qualified Trade or Business

The business must operate in a qualified trade or business, such as technology, retail, wholesale, or manufacturing. Businesses in excluded sectors (e.g., hospitality, financial services, or those reliant on employee reputation) are ineligible. The 80% active business test must be met for substantially all of the shareholder’s holding period.

3. Holding Period

The QSBS holding period begins on the date of conversion or stock issuance, not the original formation of the LLC or S corporation. This means shareholders must hold the stock for at least five years post-conversion to qualify for the 100% exclusion.

4. Business Purpose

The IRS may scrutinize conversions or reorganizations for a valid business purpose beyond tax avoidance. Documenting legitimate business reasons (e.g., facilitating investment, simplifying corporate structure, or preparing for a sale) is essential to avoid challenges to QSBS eligibility.

5. Pre-Conversion Appreciation

Only gains accrued after the conversion to a C corporation qualify for the QSBS exclusion. Built-in gains from the LLC or S corporation period are taxable, which may reduce the overall tax benefit.

6. Tax Implications

Converting to a C corporation introduces double taxation (corporate-level tax at 21% plus shareholder-level tax on dividends). Business owners must weigh the QSBS tax benefits against the loss of pass-through taxation. For S corporations, the F-reorganization preserves pass-through status for the holding company, mitigating this issue.

7. Professional Guidance

Given the complexity of IRC Section 1202 and the lack of extensive IRS guidance, consulting with experienced tax advisors and legal professionals is critical. They can ensure compliance with QSBS requirements, navigate state-specific conversion rules, and document the business purpose to withstand IRS scrutiny.

Potential Tax Benefits

The QSBS exclusion can result in substantial tax savings. For example:

• An investor contributes $1 million to an LLC, which converts to a C corporation. Five years later, the investor sells the QSBS for $11 million. The entire $10 million gain is excludable from federal income tax, saving approximately $2.38 million at a 23.8% capital gains rate (20% long-term capital gains + 3.8% net investment income tax).
• An S corporation undergoes an F-reorganization, and the resulting C corporation stock is sold for $20 million after five years, with a basis of $2 million. The $18 million gain is fully excludable (as it is less than 10 times the basis, or $20 million), saving approximately $4.28 million in federal taxes.

Risks and Challenges

• IRS Scrutiny: The IRS may challenge transactions lacking a valid business purpose or failing to meet QSBS requirements, such as the original issuance rule or active business test.
• Complexity: The F-reorganization for S corporations and asset contributions for both entities require meticulous planning and execution.
• State Taxes: The QSBS exclusion applies only to federal taxes. State tax treatment varies, and some states may not conform to Section 1202.
• Holding Period Risk: If the stock is sold before the five-year holding period, the exclusion is unavailable unless the proceeds are rolled over into new QSBS within 60 days under IRC Section 1045.

Conclusion

Converting an S corporation or LLC into a Qualified Small Business to qualify for the QSBS exclusion under IRC Section 1202 can offer significant tax savings, potentially excluding millions in capital gains from federal taxation. LLCs can achieve this through a check-the-box election, statutory conversion, or asset contribution, while S corporations typically require an F-reorganization or asset transfer to a new C corporation. However, the process is complex, with strict requirements for gross assets, qualified business activities, and original issuance. Business owners must carefully plan the conversion, document a valid business purpose, and consult with tax and legal professionals to maximize benefits and ensure compliance. By strategically restructuring, S corporations and LLCs can position themselves to take advantage of one of the most powerful tax incentives available for small business investors and founders.

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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.