United States: Is Qualified Small Business Stock An Overlooked Tax Windfall?

Congress recently made permanent a tax break for taxpayers who invest in qualified small business stock (QSBS), granting a 0% tax rate on the first $10 million of gain, or if greater, 10 times the taxpayer's investment. One commentator declared QSBS an "overlooked tax windfall" and noted:

This quotation echoes the sentiment expressed in many other publications that tout the fantastic tax savings that entrepreneurs and investors can gain using QSBS.

But is QSBS an overlooked tax windfall? As is often the case, the answer depends on the circumstances. In some cases, an investor will be better off with a limited liability company (LLC).¹

How It Works

The rules for QSBS are extremely complex and beyond the scope of this article. The basic requirements and limitations for QSBS are generally as follows:

• The stock must be acquired at original issuance and must be held for more than five years at the time of sale.
• During substantially all of the taxpayer's holding period for the stock, the issuing corporation must be a C corporation that engages in a qualified active business or is a specialized small business investment company.
• The issuing corporation's aggregate gross assets did not exceed $50 million (measured by tax basis) before or immediately after the issuance.
• The maximum gain that is eligible for the 0% tax rate is the greater of $10 million or 10 times the taxpayer's investment in the stock.

Take a relatively simple example: Investor invests $300,000 cash in stock of a C corporation meeting all the requirements for QSBS and sells the stock more than five years later for $10 million. Investor pays zero tax on the $9.7 million gain.

Assume instead that Investor sells the stock for $15 million. Investor pays zero tax on $10 million of eligible gain, and a 23.8% maximum tax on the $4.7 million excess gain. The blended tax rate is approximately 7.6%, representing a tax savings of roughly 16.2%. As the excess gain increases, the blended tax rate approaches, but never reaches, 23.8%.

So far, QSBS seems to live up to all of its hype.

An Overlooked Flaw?

One factor the articles touting the benefits of QSBS rarely mention is the lack of a stepped-up tax basis in the corporation's assets on a sale of QSBS stock at a gain. A buyer purchasing QSBS obtains a cost basis for the corporation's stock (outside basis), but will inherit the corporation's historic tax basis for its assets (inside basis).

As a result, the buyer will not be able to claim amortization deductions for any premium paid for the business. In contrast, the purchaser of LLC equity is able to "push down" its cost basis for the LLC equity to the company's assets so that the inside basis is "stepped up" to be equal to the outside basis, and the purchaser can then amortize the premium that attaches to the assets. This factor should in theory cause a tax-sensitive buyer to discount the bid price for QSBS relative to the bid price for LLC equity, effectively offsetting some or all of the tax benefit associated with the 0% tax rate for QSBS.

Because of this discount for C corporation stock (including QSBS), if there is significant excess gain, a sale of QSBS can produce less after-tax proceeds than a comparable sale of LLC equity.

Other Factors

Proponents of C corporations often argue that many buyers bid for growth companies based on a multiple of pre-tax earnings or some other pre-tax measure, and therefore there is often no discount to selling stock of a C corporation without a stepped-up tax basis. In addition, they argue that a C corporation offers benefits in terms of simplicity and familiarity for many early stage investors and their advisors. These considerations are legitimate, but hard to measure, and might be less valid as more companies operate as pass-through entities for tax purposes.

Another significant consideration in deciding whether to structure a company to issue QSBS is a selling shareholder's ability to elect under I.R.C. § 1045 to rollover gain from the sale of QSBS by reinvesting the sales proceeds into other QSBS. There is no comparable rollover election for equity in a pass-through entity.

Conclusion

Structuring an eligible small business as a C corporation so it can issue QSBS offers significant benefits if the value of the company doesn't rise too much before the eligible stockholders sell the company, and if the eligible stockholders meet the five-year holding period requirement at the time of sale. The problem is that it's difficult to know what the future will hold. If the business is highly successful (as everyone undoubtedly hopes), and/or is sold before the five year holding period, issuing QSBS could produce a worse result than structuring the company as a pass-through entity.

Because it is impossible to predict future gain and sale timing, we generally recommend choosing an LLC as the default entity for a start-up. If a later stage investor insists on a C corporation structure (an increasingly less common demand), the entity can be converted (tax-free) to a C corporation at that time and still qualify for QSBS benefits on any subsequent gain.

Footnotes

^{1 Toby Johnston, Qualified Small Business Stock Is An Often Overlooked Tax Windfall, https://blog.wealthfront.com/qualified-small-business-stock/ (Feb. 26, 2015).}

^{2 A limited partnership provides the same tax benefits as an LLC. An S corporation can produce similar tax benefits in some cases, but it generally not recommended where an LLC or limited partnership can be used.}

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.