Recent Changes Allow More Tax-free Sales of Stock by Investors in Start-up “C” Corporations and Converted LLCs with Less Than $50 Million in Assets

October 24, 2018

Section 1202 of the Internal Revenue Code allows a non-corporate taxpayer to exclude, for federal income tax purposes, 100% of the gain from a sale or exchange of “qualified small business stock” in a domestic “C” corporation acquired by the non-corporate taxpayer on or after 9/28/2010 and held by the non-corporate taxpayer for more than 5 years. The maximum amount of gain which may be excluded from taxable income by a non-corporate taxpayer upon a sale or exchange of “qualified small business stock” issued by a particular “C” corporation is the greater of $10 million or 10 times the taxpayer’s aggregate adjusted basis in such “qualified small business stock.” Where Code Section 1202 is applicable, the tax savings can be enormous.

Taxpayers hoping to capture the benefits of Code Section 1202 must comply with complex requirements set forth in the Code and also must be willing to accept, for a minimum of five years, tax burdens which are inherent in the use of a “C” corporation. Among these tax burdens are the fact that a “C” corporation’s shareholders may not deduct losses generated by the “C “corporation, and the fact that a “C” corporation’s profits are subject to two levels of tax (at the corporate level when earned, and at the shareholder level when distributed).

Because of these requirements and tax burdens, only a small percentage of new small companies formed in the decade prior to 2018 were formed as “C” corporations and actually qualified for the benefits of Code Section 1202. Since the recent enactment of the Tax Cuts and Jobs Act (the “TCJA”), however, the tax burden associated with operating as a “C” corporation has been dramatically reduced (the top rate of federal income tax on “C” corporation earnings was reduced from 35% to 21%). Although the choice to operate as a “C” corporation, an “S” corporation or a limited liability company still requires careful consideration of the relevant pros and cons, newly-formed companies and existing small limited liability companies are increasingly choosing to operate as “C” corporations. Consequently, non-corporate investors in these companies may be eligible for the benefits of Code Section 1202.

The benefits of Code Section 1202 apply only with respect to “qualified small business stock.” “C” corporation stock which is disposed of by a taxpayer generally will not be treated as “qualified small business stock” unless, among other requirements:

  1. such stock was issued by the “C” corporation to the taxpayer in exchange for money or property (other than stock) or as compensation for services;
  2. the aggregate gross assets of the “C” corporation prior to and immediately after the issuance of such stock did not exceed $50 million;
  3. during the 4-year period beginning 2 years before such stock was issued, the “C” corporation did not engage in certain prohibited redemptions of stock;
  4. during substantially all of the taxpayer’s holding period for such stock, the “C” corporation was taxable as a “C” corporation (other than a DISC or former DISC, RIC, REMIC, REIT or cooperative); and
  5. during substantially all of the taxpayer’s holding period for such stock, at least 80% of the “C” corporation’s assets were used by such “C” corporation in the active conduct of one or more trades or businesses other than
    1. any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
    2. any banking, insurance, financing, leasing, investing or similar business;
    3. any farming business;
    4. certain mining businesses; or
    5. operating a hotel, motel, restaurant or similar business.

In light of the requirements described in subparagraph (e) above, stock in a traditional professional service corporation is unlikely to be treated as “qualified small business stock,” but stock in a “C” corporation primarily engaged in product manufacturing or selling, or non-traditional services, may be eligible to be treated as “qualified small business stock.”

EXAMPLE 1: Assume individual taxpayers A and B each invest $1,000 in exchange for a 50% stock interest in a new manufacturing corporation, X. Assume that after 2 years, the value of corporation X appreciates to $10 million, and after 8 more years the value of corporation X further appreciates to $100 million. If X operates as a “C” corporation throughout the 10-year period and satisfies the various other requirements of Code Section 1202, and if at the end of year 10 each of A and B sells his stock for $50 million, then each of A and B will exclude $10 million of gain and will recognize $39,999,000 of taxable gain for federal income tax purposes.

As previously mentioned, the maximum amount of gain which may be excluded by a taxpayer under Code Section 1202 with respect to “qualified small business stock” in a particular “C” corporation is the greater of $10 million or 10 times the taxpayer’s aggregate adjusted basis in such “qualified small business stock.” Thus, the benefits of Code Section 1202 may be maximized in cases where the taxpayer’s adjusted basis in the “qualified small business stock” is likewise maximized, provided that the aggregate gross assets of the “C” corporation prior to and immediately after the issuance of the “qualified small business stock” does not exceed $50 million.

Where a limited liability company converts to “C” corporation form, and pursuant to that conversion a membership interest in the limited liability company is exchanged for “qualified small business stock” issued by the “C” corporation, Code Section 1202 treats the adjusted basis in that “qualified small business stock” as being equal to the value of the membership interest exchanged — even though the exchange may be effectuated in a tax-free manner and the value of the “qualified small business stock” received may be substantially greater than the adjusted basis in the membership interest exchanged. Thus, the benefits of Code Section 1202 may be especially valuable to a non- corporate taxpayer who receives “qualified small business stock” in exchange for an appreciated membership interest (which was acquired by the taxpayer subsequent to 9/28/2010) in a limited liability company which converts to “C” corporation form at a time when the gross assets of the limited liability company do not exceed $50 million.

EXAMPLE 2: Assume the same facts as in Example 1, except that X is formed as a limited liability company and is converted to a “C” corporation at the end of year 2. If X operates as a “C” corporation throughout the 8-year period of its corporate existence and satisfies the various other requirements of Code Section 1202, and if at the end of year 10 each of A and B sells his stock for $50 million, then each of A and B will exclude $49,999,000 of gain and neither A nor B will recognize any taxable gain for federal income tax purposes. Note how the exchange of an appreciated membership interest in a limited liability company for “qualified small business stock” dramatically increased the benefits enjoyed under Code Section 1202.

We strongly discourage companies from rushing to form as “C” corporations, or rushing to convert to “C” corporations, simply to potentially qualify for the benefits of Section 1202 without a careful consideration of all of the relevant pros and cons. We do, however, believe that in light of the changes implemented under the TCJA, newly-formed companies and existing small limited liability companies will increasingly choose to operate as “C” corporations. Such companies and their investors should carefully evaluate whether, and to what extent, benefits under Code Section 1202 may be available.

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This alert was authored by Terrence W. Stein
Direct: 312-224-1247; Email: [email protected] 

If you have any questions related to this article or would like additional information, please contact Terrence W. Stein, Chair of the Tax Group or your Fox Swibel attorney.

All materials have been prepared for general information purposes only. The information presented is not legal advice, should not be acted upon as such and subject to change without notice.

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