How Forming Your Startup as an LLC Could Maximize Qsbs Benefits

In the tech startup world, limited liability companies (LLCs) are fairly uncommon, for some very good reasons. However, in certain circumstances startups can utilize the LLC structure at formation to help maximize the potential qualified small business stock (QSBS) gain exclusion upon the sale of stock of the company, resulting in significant capital gains tax savings.

What is the QSBS gain exclusion?

Stockholders who purchase stock in small businesses with assets having a tax basis less than or equal to $50 million may be eligible to exclude from federal taxes 100%* of the capital gains upon the sale of the stock.

*Note that as of this writing, Congress has proposed to reduce the 100% gain exclusion to 50% for sales that occur after September 13, 2021. This bill could change as it goes through the legislative process, or it might not pass at all.

Say that again?

The 100% gain exclusion means NO FEDERAL TAX! (Note that some states, including California, have not adopted the QSBS rules, so state taxes could still apply.)

What’s the catch?

The caveats include the fact that the stock must be C-corporation (C-corp) stock held for more than five years, and the benefit is capped at the greater of either $10 million or 10 times the holder’s “basis” in the stock (generally this is the original cost of the stock—more on this below).

How does it normally work?

Normally, a startup is formed as a C-corp at a time when only nominal value has been created, and founders’ stock is issued with a zero (or near-zero) basis. When the stock is sold after at least five years, each founder will pay no taxes on any of the gain from the sale, up to a maximum of $10 million (it can be possible to increase this maximum amount by gifting shares to other taxpayers, each of whom have their own $10 million limit). Any gain above $10 million will be taxed at capital gains rates.

So if the startup is a C-corp at formation and founders’ stock was issued with a zero (or near zero) basis, the maximum QSBS gain exclusion is $10 million per stockholder.

How would it be different if the startup was formed as an LLC?

If the startup is formed as an LLC (and treated as a partnership for tax purposes), it would need to convert to a C-corp at some later time for the QSBS rules to apply. As long as the assets of the LLC are not valued at more than $50 million at the time the LLC converts to a C-corp, the gain exclusion is based on 10 times the fair market value of the assets of the LLC at the time of conversion.

This results from a rule that treats the basis of property as equal to its fair market value when it is contributed to the C-corp. Although this rule generally applies whenever property (other than cash) is contributed to a C-corp, the LLC conversion is the most common example of when this occurs in the startup world. The result would be similar if the startup were formed as a C-corp but the founders contributed valuable IP or other assets to the C-corp at the time of formation. In general, the shares of the C-corp would then need to be held for more than five years before being sold.

So, for example, if the startup is worth $49.9 million at the time of conversion, the maximum QSBS gain exclusion (across all founders) is $499 million! (Note this is after paying capital gains tax on the first $49.9 million in proceeds).

Why wouldn’t EVERY startup use this strategy?

This strategy may not work for everyone, for a few reasons:

• Because the basis of the stock is equal to its value for QSBS purposes following an LLC conversion, the gain is taxable at regular capital gain rates until proceeds for the shares exceed this value. In the example above, the first $49.9 million of gain is subject to capital gains tax. So if the company hits a “single” or “double,” rather than a “home run,” this approach could result in a higher tax on the founders upon exit than would be paid if the company were originally formed as a C-corp and all shares qualified for QSBS treatment.
• Waiting to convert to a C-corp will delay the start of the five-year holding period, so if you wait too long to convert, and you sell your stock in a taxable transaction before the five-year holding period expires, you could lose the QSBS benefit entirely. There are some possible exceptions related to “tacking” of holding periods and “rolling over” in a tax-free exchange, but those are beyond the scope of this post and you should speak with a tax professional to learn more.
• Moreover, if you wait too long to convert and the limited liability company’s valuation goes above $50 million at the time of conversion, then none of the stock will qualify as QSBS.
• Because the value of the company at conversion counts toward the $50 million asset limit, the founders are effectively using up some of this limit, so there may be less ability to provide the QSBS benefit to other investors. To minimize any loss of QSBS benefit for investors, consideration should be given to whether the additional basis can be reduced by depreciation or amortization over time.
• Once you convert to a C-corp with the higher valuation for purposes of maximizing the QSBS benefit, the company’s valuation for purposes of granting employee equity will likely be higher as well.
• Starting as an LLC has its downsides, including that LLCs are less common in the marketplace, less understood by investors and employees, more expensive to set up, and harder to manage from a tax perspective (e.g., the company is required to provide K-1s to members and treat members as self-employed).

So who would this strategy work best for?

You might consider speaking to us about this strategy if your startup won’t need to raise capital from institutional investors for a while (e.g. because you are bootstrapping from your own funds and/or can grow with a very small team) or if you are a seasoned, sophisticated founder and feel like you can carefully time the C-corp conversion to coincide with the maximum QSBS benefit.

I’m interested in learning more about this.

We’d be happy to chat with you. Please contact a Perkins Coie attorney to discuss your questions.