What is QSBS?
Qualified Small Business Stock (QSBS) is a powerful tax benefit for business owners or founders who operate their businesses as C Corporations. Owners of QSBS can potentially exclude all of their gain recognized on the sale of the QSBS, provided they meet certain qualifications.
However, one key requirement is that your business must be a C Corporation. QSBS is not available to owners of LLCs or S Corporations. Many founders wisely choose to form their companies as C Corporations to take advantage of this tax benefit. However, operating as an LLC initially may actually allow you to maximize your QSBS benefits.
How Much Gain Can You Exclude When Selling QSBS?
When selling QSBS, a taxpayer is permitted to exclude the greater of:
• $10 million; or
• Ten times the aggregate adjusted basis of the QSB
How an LLC Can Maximize Your QSBS Deduction
As mentioned above, you can exclude ten times the aggregate basis of QSBS. If you received your QSBS by exchanging property, the basis equals that property’s fair market value. This is significant because membership interest in an LLC qualifies as “property.”
This means that if you start your business as an LLC and convert to a C Corporation, the basis for that QSBS will be the fair market value of the LLC membership interest. Thus, if your LLC has a high valuation, this could create significant savings upon the sale of the QSBS.
For example:
Let’s say you are looking to convert your LLC into a C Corporation, and the fair market value of the LLC membership interest is $25 million. During the conversion, you exchange your membership interest for C Corporation QSBS. The basis for the QSBS will now be $25 million. You are permitted to exclude up to ten times that basis from the sale of the stock—in other words, $250 million.
If you had started your company as a C Corporation from the outset, your basis would be nominal. Consequently, the most you could likely exclude without considering other methods, such as QSBS Stacking, would be $10 million.
Key Considerations:
Holding Period: You will likely still need to hold your QSBS for five years after conversion to qualify for the exclusion.
Valuation Risk: There is a risk of converting after your LLC is valued at greater than $50 million, which could disqualify you from QSBS treatment. Thus, ensure that you have an accurate valuation of the business before you convert.
Tax Implications: You will owe taxes on any built-in gain in the LLC at the time of
conversion. However, under Section 351 of the IRC, you can defer any tax payments until you sell your QSBS.
This article is not a blanket endorsement to begin your company as an LLC with the intention to convert. However, it does highlight the importance of consulting your legal and tax advisors when planning your growth strategy. Doing so can mean the difference between saving or losing tens of millions of dollars.
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