Authors: Galen R. Mason and James W. DeCleene
Background
It has long been startup writ that U.S. entrepreneurs should form their company as a Delaware C corporation.i For a lot of founders, this can be pretty good advice. Among other reasons, VCs often prefer not to invest in pass-through entities (they do not want to be in a position to send investors K-1s and may have agreements in place prohibiting investments in pass-through entities), granting equity to employees in an LLC taxed as a partnership generally causes those employees to be viewed as “partners” rather than “employees” for tax purposes meaning they can no longer receive W-2 compensation and have to pay estimated taxes which can be confusing to rank-and-file employees, and, though C corporations are themselves taxed on their own income, that may not practically matter to a company operating at a loss with a business model of someday selling to generate a return.ii Moreover, Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”), allows certain holders of qualified small business stock (“QSBS”) to exclude up to 100%iii of the gain from the sale or exchange of said QSBS if held for more than 5 years,iv provided that the amount of gain taken into account under Section 1202 is limited to the greater of $10M or 10x the adjusted basis in the stock sold,v which may significantly enhance the desirability of incorporating as a C corporation.
1202 “Flip”
But there is an alternative to immediately incorporating as a C corporation that has potentially lucrative benefits. It involves starting out as an LLC taxed as a partnership and then incorporating as a C corporation vi at a later date—for example, when a term sheet is received from a VC that sets the pre-money valuation for the company.
The logic underlying this strategy rests on attempting to maximize the amount of gain that can be excluded under Section 1202 of the Code. As noted above, the amount of gain excludible under Section 1202 of the Code is limited to the greater of $10M or 10x the adjusted basis in the QSBS sold. In determining the 10x limitation, a basis rule—applicable solely for purposes of Section 1202 of the Code—provides that the basis of QSBS will in no event be less than the fair market value of property exchanged for the QSBS. Given this basis rule, waiting to incorporate at a time when the fair market value of the LLC has increased will generally result in an increased basis for 1202 purposes since the basis in QSBS cannot be less than the value of the property contributed to the C corporation, which would generally include the LLC’s goodwill/going concern value at that time.
So, if, following the incorporation of an LLC taxed as a partnership, a shareholder who previously held interests in the LLC has a 1202 basis in their QSBS greater than $1M (1/10 of $10M) and sells those shares, then that greater amount would apply, instead of the $10M hardwired cap, in determining how much gain is eligible for exclusion.
Here is an example:
- Two founders form a Delaware LLC taxed as a partnership with each founder owning 50% of the LLC. On Day 1, the LLC has $100,000 of assets and no liabilities.
- If the LLC incorporates on Day 1, then the basis of the QSBS held by the founders for 1202 purposes will be $50,000 each, and the 10x limit would be $500,000 for each founder, which would be less than the $10M limit if all their QSBS is sold in the same year.
- If, instead, the LLC waits to incorporate and six months later receives a term sheet conditioned on the company incorporating as a Delaware C corporation and setting the pre-money valuation of the company at $20M, each founder would have a basis in their QSBS for 1202 purposes of $10M each (based on the pre-money valuation).
- Thus, assuming all other requirements under 1202 are met, including the 5-year holding period, each founder would, upon exit, generally be able to exclude from gain up to $100M (10x the $10M 1202 basis in their QSBS).
Thus, many founders may be better off from a tax perspective by starting out as an LLC taxed as a partnership in anticipation of receiving a term sheet which sets a value on the assets in the company that they develop.vii
There can be some downsides to waiting to incorporate, and it is important to work with qualified tax and venture counsel to assess which strategy makes the most sense. Some potential downsides include the following:
- The 1202 basis rule referenced above was enacted to ensure that no appreciation occurring prior to the incorporation is eligible for exclusion under 1202.
- So, in the example above, if the founders waited to incorporate until they received a term sheet showing a $20M pre-money valuation and then ultimately sold their QSBS for $11M each, the 1202 basis in their QSBS would be $10M, and they would each have just $1M of gain eligible for exclusion under 1202. The remaining unexcluded gain would generally be taxed at normal long-term capital gains rates.
- In that event, the founders would have been better off incorporating Day 1 since they would then have had a $50,000 basis in their QSBS for 1202 purposes and would be entitled to exclude $10M of the $10.95M gain.
- The five-year holding period requirement does not start until the LLC is incorporated as a C corporation.
- The $50M aggregate gross assets test counts the corporation’s cash and the 1202 adjusted bases of its property (which, as described above, would initially not be less than the fair market value of any contributed property).viii
- Founders accustomed to processes used for C corporations may find administration of LLCs taxed as a partnership—particularly in allocating equity to larger groups of employees—to be more complex.
- Early funding of the LLC can complicate incorporations. Care should be taken to work with a qualified CPA aware of this strategy to avoid surprises.
Michael Best lawyers can help you and your co-founding team determine what is the right strategy for you and your new business. Even if you choose to start with a C corporation, we think it important that you be educated about the potential benefits and risks of alternatives.
i This article assumes the subject company is or will be a venture-backed company that will eventually be required to operate as a C corporation when taking in outside investment. As a consequence, this article primarily focuses on when a company should incorporate as a C corporation, as opposed to the general choice of entity issue of whether to operate as a C corporation, an S corporation, or a tax partnership.
ii In addition, the federal tax rate applicable to C corporations was decreased to 21% following passage of the Tax Cuts and Jobs Act, so, even where a C corporation has taxable income, it is potentially taxed at a lower overall rate assuming that it reinvests its earnings and does not pay out its earnings as dividends/excessive compensation, which would be subject to a second level of tax.
iii It should be noted that the 100% federal gain exclusion under Section 1202 of the Code applies to stock acquired after September 27, 2010. For stock acquired on or prior to September 27, 2010, a lesser exclusion percentage would apply with the excluded portion of the gain generally being treated as an AMT preference item (IRC § 57(a)(7)) and the unexcluded portion of the gain being taxed at a higher 28% rate (IRC § 1(h)(4)(a)(ii)) plus a 3.8% net investment income tax rate (IRC § 1411(a)). Given this article assumes the company has not yet incorporated as a C corporation, the 100% gain exclusion rule is assumed. Different rules may apply for state and local income tax purposes.
iv Note that the 5-year holding period is just one among many requirements under Section 1202 of the Code that must be met in order for a taxpayer to be eligible to exclude gain on the sale or exchange of their QSBS. The other shareholder- and corporate-level requirements are beyond the scope of this article.
v To be more precise, the 10x limitation is determined by reference to the aggregate 1202 bases of QSBS of the issuing corporation disposed of by the taxpayer during the taxable year. If QSBS is sold over multiple tax years, the 10x limitation is determined just with respect to the aggregate 1202 bases in the QSBS actually disposed of during that year by the taxpayer.
vi There are a number of ways an LLC taxed as a partnership can incorporate as a C corporation, e.g., a state law formless conversion, a contribution of the members’ LLC interests to a newly formed C corporation, a liquidating distribution by the LLC to its members of its assets followed by a contribution of those assets to the C corporation, etc. The pros/cons of each alternative are beyond the scope of this article.
vii Note that waiting for a term sheet is not required. For example, members of an LLC taxed as a partnership could instead get an appraisal of the entity prior to incorporating. That said, generally the best evidence of value is an arms’-length price agreed upon by a willing buyer and a willing seller, so an outside investment by an unrelated third party setting a pre-money valuation is more readily defensible.
viii This means that it could be risky waiting for a term sheet since it is often unclear what the pre-money valuation of the company will be. If the pre-money valuation is more than $50M, the corporation would violate the $50M aggregate gross assets requirement and would be ineligible to issue QSBS.