Consider using the new and improved benefits of QSBS

Often, business owners shy away from structuring as C corporations. Although the tax rate is a flat 21%, the effect of double taxation on a corporation’s dividends issued to shareholders can make the combined income tax rate prohibitively high.

Sec. 1202, which provides a partial or full gain exclusion from the sale or exchange of qualified small business stock (QSBS), is a powerful tool for founders, investors, and employees in startups and ongoing businesses that should be strongly considered. However, QSBS can only be issued by a domestic C corporation. This provision has become especially attractive in the startup and venture capital space, as it rewards investment in innovation and entrepreneurship.

Prior to the act, the gain on the sale of QSBS was excluded 100% if the stock was issued on or after Sept. 28, 2010, and, among other requirements, the stock was held for at least five years before selling it. As a result of the act, opportunities exist to receive a partial exclusion on the gain in the sale if the stock is held for a shorter period.

Specifically, under the act, for stock acquired after July 4, 2025, if it is held for three years or more, the exclusion is 50% of the gain; if it is held for four years or more, the exclusion is 75% of the gain; and if it is held for five years or more, the exclusion remains at 100%. The gain that is not excluded under the three– and four–year holding periods is taxed at 28%. However, there is an overall limitation on the excludable gain. For stock acquired on or before July 4, 2025, the amount of excludable gain is limited to the greater of either $10 million or 10 times the basis of the stock sold. Under the act, for stock acquired after July 4, 2025, the $10 million component of the limitation is increased to $15 million, indexed for inflation beginning in 2027.

As with any tax provision that offers significant income tax savings, several requirements must be satisfied. One requirement is that the stock must be acquired from the corporation at its original issue (directly or through an underwriter) in exchange for money or other property (not including stock) or as compensation for services provided to the corporation; purchases on the secondary market do not qualify. Also, for stock issued after July 4,2025, the issuing corporation must be a domestic C corporation with aggregate gross assets of $75 million (increased by the act from $50 million) or less at all times after Aug. 9, 1993, and before the issuance of the stock and immediately after the stock issuance.  The $75 million limit is indexed for inflation beginning in 2027.  The term “aggregate gross assets” is defined as the sum of cash and the aggregate adjusted bases of other property held by the corporation.

Additionally, the corporation must meet the active–business requirement in Sec. 1202(e)(1), under which at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses, and the corporation must be an eligible corporation (i.e., a domestic corporation other than a domestic international sales corporation (DISC), former DISC, regulated investment company, real estate investment trust, real estate mortgage investment conduit, or cooperative).

With these newly higher thresholds and shorter holding periods, new and existing businesses should strongly consider choosing C corporation status to take advantage of Sec. 1202. Even if an existing business is operating as a partnership, converting to a C corporation to take advantage of the Sec. 1202 benefit should be considered. The original issuance of the stock received from the corporation would be the date of conversion; as a result, the holding period of the stock for purposes of the QSBS exclusion would start on that date.  In addition, the requirement that the entity’s aggregate gross assets must be $75 million or less would need to be met before the date of conversion, as the rule applies to the corporation and any of its predecessors. A significant benefit in a conversion from a partnership to a corporation is that, for purposes of computing the 10–times–basis limitation on the gain exclusion, the taxpayer’s basis is treated as the fair market value of the stock received at the time of incorporation.

With the increased threshold and expanded benefits under Sec. 1202, consideration might also be given to terminating an S election to take advantage of the Sec. 1202 gain exemption. An S corporation cannot be treated as the original issuer of qualified stock. One potential solution is to implement an F reorganization in accordance with Sec. 368(a)(1)(F). While the specific steps are beyond the scope of this article, the general result is a newly formed C corporation that would own a single–member limited liability company through which the business would operate. As part of this structure, the issuance of the stock by the new C corporation satisfies the original–issuance criteria, allowing for possible Sec. 1202 treatment.

Careful consideration must be given before deciding to terminate a passthrough entity so that Sec. 1202 could be utilized. One very significant offsetting item is that owners of partnerships and S corporations receive a step–up in basis for income earned, whereas C corporation shareholders do not. As a result, the ultimate gain on the sale of the stock of a flowthrough entity may be significantly lower than if the entity were a C corporation, thereby reducing the relative benefit of a C corporation structure. This may be particularly true in the case where gain from the sale of Sec. 1202 stock exceeds the exclusion limitation.

It is also important to be aware that some businesses are not eligible for the exemption of gain under Sec. 1202 because they are not engaged in qualified trades or businesses for purposes of the active–business requirement discussed above. Businesses that are not qualified trades or businesses include (but are not limited to) those in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, financial services, brokerage services, or any trade or businesses where the principal asset is the reputation or skill of one or more of their employees.