Most entrepreneurs creating high-growth startups in the US form their companies without giving much thought to maximizing their potential tax benefits at the time of sale. The conventional wisdom is to form a Delaware C corporation, with the founder purchasing stock in the company at a very low price (e.g., $0.0001 per share) at formation when the value is low. For most founders, this is likely the right choice, even when taking tax considerations into account. For founders who are on a second, third or fourth startup – or who are independently wealthy – there are some different paths that can lead to significantly more tax savings in high-success outcomes.
As explained in this Cooley GO article, under current law, persons holding qualified small business stock (QSBS) for at least five years may be able to exclude from tax all or a portion of their gain from the sale of QSBS.1 The QSBS gain exclusion for each stockholder is limited to the greater of $10 million or 10 times the stockholder's basis in the QSBS that is sold. Strategies for increasing the potential QSBS gain exclusion focus on one of two things: increasing the stockholder's basis in the QSBS, often accomplished through limited liability company (LLC) and partnership conversions, and increasing the number of stockholders eligible for the QSBS gain exclusion, which is known as "stacking." This post describes these QSBS-maximizing strategies that entrepreneurs may consider.
Please note that this article addresses US federal income tax only and does not address any state or local tax implications. Some states, including California, do not provide a state income tax exclusion analogous to the federal QSBS gain exclusion, so gain on the sale of QSBS may still be subject to state income tax in those states.
Finally, the information in this article does not change the fact that for most entrepreneurs, especially first-time entrepreneurs, the strategies described below are too advanced and complicated to execute, with significant variables to achieving a successful outcome, and as a result, the vast majority of these founders will still follow the tried and true Delaware C corporation formation route.
LLC and partnership conversions
An entrepreneur who acquires shares in a corporation for a nominal amount will have a very low basis in the shares. As a result, on a sale of stock, the entrepreneur with low basis will be able to exclude a maximum of $10 million of gain from tax, assuming the other QSBS requirements are met. In significant upside scenarios where more than $10 million of gain is realized, this will mean that some of the entrepreneur's gain on the sale of QSBS will be subject to tax.
If the business is conducted initially in a partnership, including an LLC with more than one member that is taxable as a partnership, a conversion to corporate form may significantly increase future QSBS benefits because of the 10x basis gain exclusion. The US tax code includes a special rule that when a taxpayer acquires QSBS for property other than cash or stock, the taxpayer's basis for QSBS purposes will not be less than the fair market value of the property. This rule ensures that the built-in gain in property exchanged for QSBS eventually will be fully taxed. But it also means that the owners will be able to calculate their gain exclusion based on 10x the value of the partnership or LLC at the time of the conversion.
Below are some examples of how this works.
On day 1, two founders form a Delaware corporation that is taxable as a C corporation. Each founder acquires 50% of the stock in the corporation for a nominal price. Six years later, the founders sell the stock, which qualifies as QSBS, for $400 million. The founders have gain of ~$400 million in the aggregate, of which a total of $20 million is exempt from tax (because each founder has a $10 million gain exclusion), and $380 million is subject to tax.
On day 1, two founders form a Delaware LLC that is taxable as a partnership. Each founder acquires 50% of the units in the LLC for a nominal price. A few years later, when the LLC's assets are worth $40 million, the founders convert the LLC to a C corporation. The founders' QSBS basis in the C corporation stock is an aggregate of $40 million – i.e., $20 million per founder. Five years after the conversion, the founders sell the stock for a total of $400 million. The founders have a total gain of ~$400 million in the aggregate, of which $40 million (the appreciation in the property exchanged for the QSBS when the LLC was converted to a corporation) is subject to tax, and the remaining $360 million is exempt from tax (because each founder has a gain exclusion of up to $200 million – that is, 10x each founder's $20 million basis in the QSBS).
As illustrated above, the greater the sales proceeds, the more favorable an LLC conversion will be from a QSBS perspective. Accordingly, entrepreneurs who want to maximize QSBS benefits on exit should consider forming their business as an LLC and later converting to a corporation.
The LLC conversion strategy is not without downsides, however.
In an LLC conversion, the entrepreneur's five-year holding
period will start upon the conversion, rather than when the
business is formed. In addition, the conversion must occur prior to
the time at which the aggregate gross value of the company's
assets exceeds the $50 million threshold applicable to
"qualified small businesses." A valuation typically
should be done at the time of the conversion to substantiate the
taxpayer's position that the fair market value of the LLC's
assets is less than $50 million, and the valuation should be
consistent and coordinated with valuations used for other purposes,
such as under Section 409A and for financing rounds. In certain
scenarios, such as when the LLC is leveraged, the conversion may
result in tax to existing owners.
Because appreciation in the company's assets at the time of conversion is not exempt from tax upon a subsequent sale of the QSBS, this strategy could decrease QSBS benefits if the deal value in excess of such appreciation is not sufficient to fully utilize the available gain exclusion.2 And owning and operating an entity taxable as a partnership is generally more complex from a legal and tax perspective than owning and operating a C corporation. Entrepreneurs should consult their tax advisers before proceeding with this strategy.
Please also note that the LLC conversion strategy is not available for business conducted as an S corporation, another type of pass-through entity. Stock issued by an S corporation generally is not QSBS eligible. Strategies to establish a QSBS position upon conversion of an S corporation are complex and beyond the scope of this article.
'Stacking' the $10 million QSBS gain exclusion
Another potential strategy for maximizing QSBS benefits, commonly known as "stacking," involves increasing the number of taxpayers who can take advantage of the QSBS gain exclusion. The QSBS gain exclusion is generally applied on a per-issuer and per-taxpayer basis, meaning that the overall QSBS gain exclusion would be increased if more shareholders own QSBS in the company. For instance, if one entrepreneur who has a nominal basis in QSBS sells QSBS at a $100 million gain, the entrepreneur will only be able to exclude $10 million from tax. By contrast, if three equal co-founders with nominal bases in their QSBS sell their QSBS at a $100 million gain, the overall QSBS gain exclusion will be $30 million ($10 million per co-founder).
Stacking involves a holder of QSBS transferring shares to other taxpayers in order to increase, or stack, the QSBS gain exclusion. Because the QSBS rules generally require that QSBS be acquired at original issue from the corporation, selling QSBS to other taxpayers is not an option, since those shares would not qualify for QSBS benefits. Gifts, however, generally are exempt from the original issue requirement. As a result, stacking typically involves the gifting of QSBS to family members or certain nongrantor trusts. In order to minimize gift tax, such transfers are often done at an early stage, when the value of the QSBS is relatively low. The QSBS rules deny stacking benefits for transfers between spouses who file separate tax returns. The treatment of transfers between spouses who file joint returns is unclear.
Stacking – particularly through numerous gifts of QSBS – may be inconsistent with the policy underlying QSBS, and therefore is susceptible to IRS challenge. Taxpayers who are interested in QSBS stacking should consult their own tax advisers about the availability, and potential consequences, of this strategy. Entrepreneurs also will want to consider whether the potential QSBS benefits from stacking are worth the uncertainty involved in transferring stock to other persons, even if those other persons are related, as well as the gift tax consequences.
1 A number of requirements must be met for stock to qualify as QSBS – including that the issuer is a US C corporation that has gross assets of $50 million or less at all times before and immediately after the issuance of the QSBS, has not redeemed significant amounts of its stock, and has been actively engaged in a "qualified trade or business" for substantially all of the taxpayer's holding period. In addition, the stock generally must be acquired directly from the corporation in an original issuance.
2 For instance, in the scenarios above, if the founder sold QSBS for $39 million, the founder would have been better off forming as a C corporation from the outset, since the founder would have $29 million of taxable gain in the corporate formation scenario ($39 million of gain less a $10 million QSBS exclusion) and $30 million of taxable gain in the LLC conversion scenario (the first $30 million of gain taxable since that was the appreciation at the time of conversion, with the remaining $9 million of gain eligible for QSBS exclusion). Additionally, the founder would have met the five-year holding period requirement sooner if the company had been formed as a C corporation from the outset, because the holding period would start at inception, whereas it would only start at the later time of conversion in the LLC conversion scenario.
Many thanks to Eileen Marshall and Patrick Sharma for their assistance with this post.
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.