It is often said that any new start-up business that is planning on raising equity investments from the private equity/venture capital (PE/VC) world generally needs to organize themselves as a corporation, rather than as a limited liability company (LLC). Although the merits of this statement are debatable, the most oft-cited reason for the statement is that LLCs are generally taxed as partnerships. Many PE/VC investment funds are backed by tax-exempt investors consisting of pension plans, endowments, or similar entities, many of which can have adverse income tax consequences by making an investment in an operating business that is taxed as a partnership. Although there generally are various legal structures available that can mitigate such consequences, the desire for simplicity sometimes mandates that the operating business be organized as a corporation from the outset.
Recent developments in the tax law might give entrepreneurs reason to re-think these assumptions.
The Small Business Jobs Credit Act of 2010 was signed into law on September 27, 2010, followed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which was signed into law on December 17, 2010. These new laws contained several provisions that were designed to incentivize and stimulate business activities, including some tax law changes. One of the more important tax law changes included in these packages were amendments to Section 1202 of the Internal Revenue Code (Code). These amendments were intended to apply a complete federal income tax exemption (i.e. a zero-percent federal tax rate) for gains recognized by non-corporate investors on the sale of qualified small business stock (QSBS) that is held for more than five years, but only if (among other requirements) the QSBS is purchased after September 27, 2010 and before January 1, 2012.1 In other words, this is a limited time offer that is clearly designed to encourage new investments in QSBS during the final calendar quarter of 2010 and during calendar year 2011.2
But, the amount of gain that qualifies for this zero-percent federal income tax rate is subject to a cap. Assuming that a stock investment meets all of the applicable requirements under Section 1202 of the Code, the aggregate amount of gain for any taxpayer with respect to an investment in any single issuer that may qualify for these benefits is generally limited to an amount equal to the greater of $10 million or 10 times the taxpayer's adjusted tax basis in the QSBS.3 For a taxpayer who invests cash in the QSBS, the tax basis would generally be equal to the cash purchase price. However, a special rule is provided for cases where a taxpayer instead purchases the QSBS for in-kind property (i.e., other than cash). In such cases, the taxpayer's basis in the QSBS, solely for purposes of these Section 1202 rules, is deemed to be the fair market value of the property transferred for such QSBS.4 This special rule is key to understanding how Section 1202 may apply to LLC operating businesses.
For example, assume that an entrepreneur organizes a new business venture on July 1, 2011 as a corporation. The entrepreneur initially funds the venture with $20,000 of his own money and is initially the owner of all of the corporation's outstanding stock. Assuming that the stock meets all the other applicable requirements for QSBS5, the entrepreneur can qualify for a zero-percent federal income tax rate on a subsequent sale of his stock, presuming he holds it for more than five years. However, the amount of gain that qualifies for this zero-percent rate is subject to cap equal to the greater of $10 million or 10 times his original basis of $20,000. Thus, the maximum amount of gain eligible for the zero-percent tax rate in this example would be $10 million.
By contrast, assume the same facts as above except that the entrepreneur instead organizes the venture as an LLC on July 1, 2011. Then, between July 1 and December 31, 2011, the value of the business increases to, say, $5 million, at which time the entrepreneur (still the 100-percent owner) converts the LLC into a C corporation and exchanges all of his LLC membership interests for newly issued stock of the C corporation. Again, assuming that the stock meets all the other applicable requirements for QSBS (see footnote 5, infra), the entrepreneur can qualify for a zero-percent federal income tax rate on a subsequent sale of his stock, presuming he holds it for more than five years. However, in this example, the amount of gain that qualifies for this zero-percent rate is subject to cap equal to $50 million dollars, rather than $10 million. This is because the stock in the new corporation is acquired by the entrepreneur in exchange for his in-kind interests in the LLC's business assets. Thus, the special rule described above would ascribe to him an initial tax basis (solely for Section 1202 purposes) equal to $5 million, which is the value of such in-kind assets.6 Thus, the maximum amount of gain that qualifies for the zero-percent federal income tax rate is equal to the greater of $10 million or 10 times this initial investment, or $50 million.7
In other words, simply by organizing the venture as an LLC for the initial few months, during which the initial value of the new business is created, the entrepreneur, in this example, is potentially able to qualify an additional $40 million of gains from federal income taxation, a tax savings of $6 million or so (or more if tax rates increase, as expected, in upcoming years). Given that a conversion of an LLC to corporate status can be done relatively simply and tax efficiently,8 all entrepreneurs who are organizing new start-up ventures in the coming months should definitely consider these (among other) tax considerations in deciding on corporate versus LLC status.
It should be noted that any decision to organize a business venture as an LLC, as opposed to a corporation, can have many other tax consequences in addition to those identified above, each of which need to be carefully analyzed based on the surrounding facts and circumstances. Please consult with a tax and legal advisor in connection with these considerations.
1. See IRC § 1202(a)(4).
2. Recent Obama administration budget proposals have proposed making the zero percent federal income tax rate on QSBS permanent (i.e., applicable to all QSBS acquired after September 27, 2010).
3. See IRC § 1202(b)(1).
4. See IRC § 1202(i).
5. For a summary of the technical requirements under the Code for qualification as QSBS, see Foley's previous alert: http://www.foley.com/publications/pub_detail.aspx?pubid=7611.
6. See IRC § 1202(i)(1).
7. Upon a subsequent sale of the stock by the entrepreneur, the first $5 million of gain would be subject to regular capital gains rates, with the next $50 million above that being eligible for the zero-percent rate.
8. See IRC § 351 (generally providing for tax free treatment upon transfers of appreciated property to newly formed corporations in exchange for stock, subject to certain requirements).
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.