Only C-Corporations can qualify to issue Qualified Small Business Stock (QSBS) per Section 1202.

C-Corporations or “C-Corps” are legal entities in which the owners or shareholders are taxed separately from the entity.   C-Corps are taxed on their income before paying out earnings in the form of dividends to shareholders, and those distributions are then taxed at the individual shareholder level – creating for “double taxation”.

S-Corporations on the other hand are considered to be “pass-through” entities as they pass income directly to shareholders. Income taxes are therefore only assessed at the individual partner level.

Benefits of Becoming a C-Corp

Early stage companies find the C-Corp structure appealing because:

  • C-Corps limit the liability of investors and firm owners.  The most an investor can lose if the business were to fail is what they have invested into the business.
  • C-Corps can issue different types of equity instruments such as convertible stock or preferred stock, which institutional investors generally prefer over common equity.
  • C-Corps can issue stock options and “incentive stock options” to motivate and compensate their employees.
  • The potential tax savings on capital gains through QSBS may outweigh the “double taxation” issue, especially if the Company has no or limited taxable earnings. 

Of course, if presented with two similar investment opportunities, investors may prefer the C-Corp as their gains may be excluded from taxes if they qualify as QSBS!

How to tell if a Company is a C-Corp

To become a C-Corp, a company must file Articles of Incorporation with the Secretary of State and file IRS Form SS-4 to obtain an employer identification number (EIN).   

A few indications that the Company is likely a C-Corp include:

  • Name ends with either the identifier “Incorporated” or “Corp”.
  • Business has a Board of Directors
  • Business was formed by filing Articles of Incorporation

You can search state databases to check the entity’s status. 

For example, Delaware C-Corps can be looked up on the Delaware Division of Corporation’s website.  

What if the Corporation Wasn’t Always a C-Corp?

In order to qualify as QSBS, the corporation has to be a C-Corp on the investment date, but not before.

If the business was formed as a different legal structure (e.g. LLC, S Corporation, Partnership), the company can terminate its legal structure to re-incorporate as a C-Corp before the issuance/sale of the stock. 

Converting a legal entity raises various complications.  For example, if an entity is converting from an S-Corp to a C-Corp, it is not as simple as transferring stock for stock in the new entity as stock-for-stock transfers do not qualify for QSBS. It may be possible for the owners of the S-Corp to transfer the assets of the S-Corp to a C-Corp in exchange for QSBS under a tax-free exchange pursuant to IRC Section 351(a). If the stock received from the C-Corp qualifies as QSBS, the owners of the S-Corp will realize the QSBS tax exclusion through their S-Corp K-1. 

Do All C-Corp’s Qualify for QSBS?

The general intent of QSBS is to encourage development of companies that are created to drive new innovations and spur job creation, however not every type of C-Corp can qualify for issuing QSBS. 

Companies incorporated in the U.S. as C-Corps are eligible for QSBS unless the corporation was formed as:

  • Domestic International Sales Corporations (DISCs), which are entities designed to facilitate the US government to subsidize the export of US made goods
  • Regulated Investment Companies (RICs), which are investment entities and can take the form of Mutual Funds, Exchange-Traded Funds (ETFs), Real Estate Investment Trust (REIT), or Unit Investment Trusts (UITs). 
  • Real Estate Mortgage Investment Conduits (REMICs), which are entities that hold a fixed pool of mortgages and issue multiple classes of interests in itself to investors. 
  • If the corporation or a subsidiary is electing a Section 936 tax exemption, which primarily provides a tax credit for certain kinds of businesses in Puerto Rico.

A C-Corp can conduct business internationally, but it has to be incorporated in the US to qualify for QSBS.

Can an LLC Taxed as C Corporation Qualify for QSBS?

Section 1202 states that a ” ‘qualified small business’ means any domestic corporation which is a C corporation” and does not explicitly state treatment for an LLC taxed as a C Corporation.

Although this is true,  in Ltr. Rul. 201636003 a tax-free reorganization involving an LLC taxed as a C Corporation and converted to a C Corporation to qualify as QSBS with a holding period starting the date that the membership interest in the LLC was acquired. This means the IRS viewed the membership interest in the LLC taxed as a C Corporation as QSBS for Section 1202 purposes.

This ruling implies that the membership interest was QSBS before it was converted to a C Corporation. Therefore, there is a reasonable basis given this case to consider an LLC taxed as a C Corporation to likely be considered QSBS.

Do Startups With No Revenue Qualify for Section 1202 QSBS?

Section 1202(e) explicitly states that “start-up activities” under Section 195(c)(l)(A) or research/experimental activities under Section 174 or Section 41(b)(4) will receive special treatment when testing for the active test.

Therefore, if an angel investor is investing in a startup company that is pre-revenue and is still in the idea stage, trying to reach product-market fit, the stock will still qualify for Section 1202 QSBS if the company and the investor check off all of the boxes on the QSBS checklist.

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

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