Maximizing “Qualified Small Business Stock” Benefits When Converting an S Corporation to a C Corporation
With increasing frequency in recent years, we’re seeing shareholders of an S corporation decide to convert their flow-through business to a C corporation. There are several possible reasons for this change of heart. Perhaps the shareholders want to issue preferred equity to an outside investor (an S corporation can have only one class of stock, which generally can be held only by US individuals – no entities or foreign taxpayers). Or maybe the shareholders are swayed by the 21% federal income tax rate now applicable to C corporations (and dismayed by the complexity of the 20% deduction available to certain owners of flow-through businesses). Or possibly the shareholders discovered that they can exclude all the gain from “qualified small business stock” (QSBS) held for more than five years, which includes only stock held in a C corporation. But regardless of the reason for converting their S corporation to a C corporation, the shareholders should pay extra close attention to the manner in which they convert, or they could be leaving millions of dollars of tax savings on the table.
This potential pitfall stems from the QSBS requirements under Section 1202 of the Internal Revenue Code. Very generally, a shareholder who acquires QSBS after September 2010 and sells the stock after holding it for more than five years can exclude from income the greater of $10 million or 10 times the shareholder’s basis in the stock. We can’t get into all the QSBS requirements in this short post – and there are quite a few requirements to consider. Instead, we’ll focus only on the “original issuance” requirement in which the shareholder must acquire the QSBS directly from the corporation when the corporation was a C Corporation. As a consequence, simply revoking a corporation’s S status will not qualify the former S corporation stock as QSBS.
S corporation stock cannot become QSBS, but the QSBS rules generally do permit an S corporation to hold the stock of a subsidiary C corporation as QSBS and pass through to its shareholders any Section 1202 exclusion when the stock of that C corporation is sold. Accordingly, shareholders that wish to effectively convert an S corporation to a C corporation can cause the S corporation to contribute all its assets to a newly formed C corporation, which would then become a wholly owned subsidiary of the S corporation. The S corporation may then hold the C corporation stock as QSBS and avail itself of the Section 1202 exclusion on the subsequent appreciation in the value (the exclusion would not apply to value appreciation while the business was an S corporation).
Unfortunately, this approach does call for an actual transfer of assets – Section 1202 does not permit the transfer of the existing S corporation’s stock to a new holding company. An actual asset transfer can be cumbersome, e.g., the new C corporation will operate the business under a new EIN, there could be license or contract assignment issues, and the asset transfer to the new C corporation must qualify as a tax-free transaction. But the rewards of a 0% federal tax on all or a portion of one’s capital gain upon exit may be quite significant.
Application to Venture Capital Financings
Many of our clients and co-counsel regularly see S-to-C conversions in the context of VC financings of startups that began life as S corporations. Whether because the new investors are purchasing preferred stock, or they are purchasing common stock but they are ineligible to hold stock in an S corporation, the sale of the existing corporation’s stock would terminate its S election. The corporation goes forward as a C corporation beginning on the date of the sale.
From the new investor’s perspective, the stock they purchase in the now-C corporation may be QSBS without any special structuring like that described above. The founders and other existing shareholders, however, need special structuring to avail themselves of QSBS benefits for their existing stockholdings.
In all events, it’s critical to consult a knowledgeable tax advisor on S-to-C conversions or acquisitions of QSBS generally. The discussion above is a highly simplified summary; there are exceptions, limitations, and other thrills, chills, and spills that must be considered based on one’s particular circumstances. But again, the tax savings for QSBS may easily merit the trouble of advance planning.
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