Will Starting as an LLC Impact Your QSBS Tax Savings?

Since startups can scale rapidly, investments in such entities can provide multifold returns. For instance, ElevenLabs’ valuation grew from $100 million to $3.3 billion in just 2 years. This reflects a CAGR of 474.46%. However, a chunk of these returns is often captured in the form of taxes if the business does not issue Qualified Small Business Stock (QSBS).

Founders often overlook this tax-saving tactic, assuming that its only purpose is to attract investors. In fact, since founders typically have the longest holding periods, they can easily meet the QSBS holding requirements and potentially exclude 100% of capital gains upon their eventual exits.

Normally, under Section 1202 of the Internal Revenue Code (IRC), investors can exclude up to $10 million of gains or 10 times their QSBS investment basis. Since the greater of the two values is applicable, founders can make capital gains tax exclusions that far exceed the $10 million limit.

What are the key requirements of QSBS treatment?

If you meet certain stringent requirements relating to company structure, redemption timelines, and holding period, you can unlock significant tax savings through QSBS treatment. First, let us understand what kind of companies can issue QSBS. Certain businesses that are excluded from QSBS treatment are:

• Hospitality
• Farming
• Certain mining and natural resource extraction businesses
• Certain banking and financial services businesses
• Businesses where the reputation or skill of 1 or more employees is the principal asset

Section 1202 of the IRC states that only US corporations with gross assets worth up to $50 million, of which 80% are actively engaged in a qualified business, can issue QSBS. Such a share issuance must occur after 10th August 1993. The asset value requirement must be met before and immediately after the QSBS issuance.

Furthermore, such stocks will not qualify for QSBS treatment if the company’s redemption rate is more than 5% of the total outstanding shares in the period starting from 1 year prior to and ending 1 year post the share issuance.

Shareholders who wish to avail QSBS tax benefits must receive stocks in exchange for money, service, or property, but not stocks of any kind. So, you cannot qualify for QSBS treatment if you receive the shares of a QSB in a share swap.

You will also lose these benefits if your holding period is less than 5 years. Additionally, from 2 years prior to 2 years post the share issuance, the company cannot purchase its stock from you or anyone related to you.

How does starting out as an LLC impact tax savings under QSBS provisions?

From a founder’s perspective, starting out as a C-corporation is better than starting as a limited liability corporation (LLC). This is because the holding period would start only once the company converts to a C-corporation.

So, suppose you establish your company as an LLC and then convert it into a C-corporation two years later. Then, you would have to hold on to your stocks for another five years to qualify for QSBS treatment. As a result, your total required holding period would be seven years.

Another key consideration is the fact that QSBS treatment is not applicable if stocks are received in exchange for stocks. So, you can not start off as an LLC, establish another C-corporation, and receive the C-corporation’s shares in exchange for LLC shares if you want QSBS benefits.

Instead, you must take the following conversion route:

• Set up your company as an LLC.
• When your business’s gross assets reach $50 million, you must execute an assets-up transfer. This involves liquidating the LLC, distributing its assets to members, and the members transferring these assets to the new C-corporation in exchange for its shares.
• You must hold stocks for at least 5 years and adhere to redemption requirements to make capital gains exclusion of up to $500 million (10x the maximum gross asset value, i.e., $50 million).

In such a conversion, your QSBS investment basis must be set at the fair market value (FMV) of the assets on the date of the exchange.Thus, due to the extended holding period and complex conversion process, if you intend to take advantage of QSBS provisions, you should ideally start off as a C-corporation.

When to start as an LLC before switching to a C-Corp

Starting off as an LLC and then pivoting to a C-corporation makes sense only under very specific circumstances, which are described as follows:

• Not planning to raise funds – QSBS qualification is an excellent way to attract investors because of the tax benefits. Since the need for funds is most acute at inception when there are little to no positive cash flows, if you plan to raise funds, especially from individuals, you should start off as a C-corporation.
• Single taxation benefits – LLCs do not pay taxes; rather, the profits are transferred to the owners and then taxed. In contrast, in a C-corporation, profits would be taxed at the business level as well as after distribution. So, if you are confident that your business would hit the ground running and the benefits of pass-through taxation outweigh the QSBS capital gains exclusion benefits, you can consider starting out as an LLC.
• Flexibility in profit distribution – In comparison to C corporations, LLCs have more flexibility in setting profit-sharing terms. Even if ownership is distributed equally, profits can be allocated disproportionately to reflect differences in each member’s non-financial contributions, such as effort and expertise.
• Loss write-off – If you have multiple income streams and wish to minimize your tax liabilities, setting up your business as an LLC can be advantageous. Any losses incurred by the LLC will be passed through to you, effectively reducing your taxable income. This route is ideal for entrepreneurs expecting early-stage losses and not seeking immediate external funding.
• Short holding period – Not all businesses are set up to disrupt value chains. Some are established to exploit short-term opportunities with agility or to become attractive acquisition targets by capturing markets valuable for other larger entities. If you have similar immediate goals for setting up your business, you need not jump through all the hoops for QSBS qualification.

Considerations before converting into a C-corporation

Before you convert your business into a C-corporation, you must weigh the impact of the following considerations.

• Higher operational costs – As a C-corporation, your business must pay for professional accounting and bookkeeping services, annual report fees, franchise taxes, Form 1120 preparation charges, legal fees, registered agent renewal fees, and meeting and record-keeping costs. If all these costs are applicable in your case, they can amount to at least $6,000 annually.
• Higher tax liabilities – When your business is set up as an LLC, you are taxed only on the profits distributed to you. In contrast, C-corporation owners face what’s commonly referred to as ‘double taxation’ wherein the corporation pays taxes on its profits and shareholders pay taxes on dividends. However, this term can be misleading as corporations and individuals are subject to federal as well as state taxes. So, in effect, LLC owners would be taxed twice and C-corporation owners would be taxed four times, twice at the corporation level and twice at the individual level.
• Stricter regulations and compliance requirements – C-corporations must comply with various governance and recordkeeping requirements. These requirements include establishing a board of directors, holding board meetings regularly, enabling shareholders to vote on key issues, and registering with the SEC when issuing securities, if certain thresholds are met.

Eqvista – Simplifying compliance, unlocking tax savings!

Converting to a C-corporation is crucial in positioning your company for QSBS tax benefits, but strategically timing this conversion is equally important. Starting as an LLC offers flexibility in the early stages, but entrepreneurs should carefully weigh this against the five-year holding period required for QSBS qualification.

By planning your entity structure with both immediate and long-term exit strategies in mind, you can maximize potential tax savings when selling your qualified small business stock.

Don’t leave these significant tax advantages to chance—partner with Eqvista to navigate the complexities of QSBS qualification and equity management. Our platform and expert team will help you make informed decisions about when to convert your LLC to a C-corporation, track your qualification timeline, and ensure you’re positioned to take full advantage of this powerful tax incentive when exiting your business. Contact Eqvista today to start optimizing your company structure for QSBS benefits.