Just when we thought we were all set when it came to choosing an entity for small businesses…here we go again.

When tax rates were 35% for corporations and 39.6% for individuals it was straightforward to decide whether to be a C Corporation or to elect to set up your entity as a pass-through Subchapter S or LLC. Although the C corporate rate was lower by a few points, C Corporations still had the potential for double taxation, once at the entity level and then again on distributions or liquidations.

The Tax Cuts and Jobs Act of 2017 (TCJA) dropped the corporate tax rate to 21%, making it very tempting to operate as a C Corp. However, after considering the potential 199A deduction, the effective tax rate for pass-through entities could be as low as 29.6%. Still higher than 21% but no double taxation. Pass-through treatment recently became even more compelling, since several states have either enacted or are considering legislation that provides a SALT (state and local tax) workaround. (see Pass-Through Entity Tax article and FAQ)

Now we must factor in President Biden’s new tax proposals. His plan is to raise the corporate tax rate to 28%. Additionally, he is proposing to raise the top capital gains tax rate from the current 20% to 39% (nearly 43% with Net Investment Income Tax (NIIT).  

Why would it ever make any sense to operate as a C Corporation? Well, in certain circumstances it might prove to be extremely beneficial.

There is an old but seldom used set of rules under Internal Revenue Code section 1202 that impacts this decision. Under Sec. 1202, taxpayers can exclude taxable gains from the sale of Qualified Small Business Stock (QSBS) in a qualified C Corporation. Although the rules are complex, the results are remarkably favorable for individual taxpayers.

Up to 100% of the gain you realize when you sell QSBS can be exempt from income taxes. The maximum amount of the exclusion is the greater of $10 million ($5 million if married filing separately [lifetime limit for each investment]) or 10 times your original investment annually.

As an example, a person investing $250,000 in a QSBS in 2021 may sell that stock five or more years later for up to $10 million and not pay federal income tax on the gain (or state taxes in the 46 states that follow federal law, with notable exceptions in California, Mississippi, New Jersey, Pennsylvania and Wisconsin). Or, if you invested $2 million in a QSBS in 2021, you could sell that stock five or more years later for up to $20 million and exclude 100% of the gain.

To qualify for the QSBS exclusion, a few requirements must be met:

• Stock must have been issued by a domestic C Corporation after August 10, 1993.
• Aggregate tax basis of the corporation’s assets cannot exceed $50 million before and immediately after the issuance.
• The stock must have been issued by a corporation that uses at least 80% of its assets in an active trade or business. Certain trades or businesses are specifically excluded from IRC Sec. 1202, including most professional service firms, finance and investment management businesses, and hospitality businesses.
• The taxpayer must have received the stock at original issue (i.e., not in a secondary sale) in exchange for money, other property or services.
• The stock must be held for at least five years.

While an investment may qualify for QSBS treatment, it is important to note that the benefit of the exclusion is only fully realized once the stock is sold. Because a company's assets are often more attractive to buyers than its stock, Sec. 1202 cannot be used to exclude corporate-level gains from the sale. However, as long as the corporation subsequently distributes the proceeds of the sale to its shareholders in a complete corporate liquidation, the shareholders should be able to use the exclusion for the gain upon the liquidation. Although the statute is silent on the issue, Sec. 331 treats amounts a shareholder receives in a complete corporate liquidation as being made in exchange for the stock.

Additionally, QSBS acquired between August 10, 1993 and Sept. 28, 2010, does not qualify for a 100% exclusion and is subject to a partial alternative minimum tax (AMT) adjustment on any gain excluded under Sec. 1202.

Maximizing Overlooked Opportunities

Additional planning techniques can enable taxpayers to take advantage of some overlooked opportunities.

Expanding the $10 million exclusion cap can be done in three ways:

• Strategic structuring The QSBS exclusion applies to each taxpayer separately on a per-issuer basis, so multiple shareholders in an issuing company would qualify for separate exclusions on their respective eligible gains. Therefore, founders or investors can structure their initial investment accordingly and include their spouse, adult children and other family members, non-grantor trusts, limited partnerships, LLCs and S corporations.
• Gifting A founder or investor may be reluctant to split his interest on day one. Nevertheless, if at a later date it appears likely that the gain from the QSBS will exceed the $10 million cap, it may be possible to gift shares outright. Although the rule for QSBS is that it must be sold by the original holder, gifting QSBS stands out as an exception to that rule. The recipient of the gift basically steps into the shoes of the original holder. Of course, the QSBS should be gifted when the shares’ value is as low as possible to avoid using a substantial portion of the person’s lifetime exclusion or having to pay gift taxes.
• Stacking This is done by creating multiple non-grantor trusts for the benefit of various family members. Note, however, that two or more trusts will be treated as one if they have “substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries” and if the primary purpose was to avoid federal income tax. Upon gifting QSBS to each trust, the trust will be substituted for the grantor as far as the holding period requirements and each trust will be entitled to its own exemption.

Sidestepping the five-year holding period:

• To qualify for the QSBS tax exemption, you must hold the stock for five years. A problem arises when a liquidating event occurs before that time. Fortunately, you may still qualify if you roll over the proceeds within 60 days from one QSBS to another, using a tool from IRC Sec. 1045. This 1045 rollover tacks the original investment’s holding period onto the new one, to complete the required five-year term. By way of example, if you hold QSBS in Corp. A for three years then, upon a sale, roll the proceeds over into QSBS of Corp. B, you will only have to hold QSBS of Corp. B for two more years to qualify for the 100% exemption. Under the 1045 rollover provisions, there are no limits on how much you can roll over nor how many times you can elect rollover treatment. Moreover, the replacement stock doesn't have to be of only one company: the proceeds can be rolled over into a diversified portfolio of QSBS holdings, and the gain is still deferred.

Bottom Line

Making the decision to incorporate as a C Corporation requires significant thought and foresight. Newly formed development stage companies (in qualified trades or businesses) would seem to be the ideal candidates. In general, these companies would be start-ups with little or no taxable income for several years, would have assets of under $50 million, would not pay dividends, and would generally not be sold within the first five years. The upside on these types of investments could be very high, and if the gain is tax-free, it would be a home run. 

The issues relating to QSBS and 1045 rollovers, as well as the provisions under IRC Code Section 1202 and 1045, are very complex. Therefore, working with an accountant and lawyer experienced in this area is crucial. Please keep in mind that the above is based on current tax laws. Tax law changes can significantly affect QSBS and 1045 rollover planning techniques.