In the U.S., many entrepreneurs dive into the startup world without a deep understanding of how to maximize potential tax benefits upon selling their businesses. Traditionally, they establish a Delaware C corporation and acquire shares at a minimal cost when the business value is still low. This approach might work for a majority, particularly first-time entrepreneurs. But for seasoned founders or those with significant wealth, alternative methods could lead to notable tax savings when they hit a jackpot.
One such method revolves around qualified small business stock (QSBS). By current U.S. federal law, if you hold QSBS for at least five years, you might be able to exempt some or even all of your profits from taxes when you sell the QSBS. However, each stockholder’s QSBS gain exclusion is restricted to the larger of either $10 million or ten times their initial investment in the QSBS. Entrepreneurs can maximize this exclusion in two primary ways:
- Boosting the Original Investment in the QSBS: This often involves converting a limited liability company (LLC) or partnership into a corporation.
- Increasing QSBS Owners: Commonly referred to as “stacking”, this method seeks to expand the number of shareholders eligible for QSBS gain exclusions.
However, it’s essential to remember that this article focuses only on U.S. federal income tax. Some states, like California, don’t offer state income tax exclusions similar to the federal QSBS gain exclusion, meaning even if you’re exempted from federal taxes, you might still owe state taxes.
For those considering the LLC conversion, the premise is simple: instead of establishing a corporation from the get-go, begin with an LLC and then convert it to a corporation. By doing this, the founder’s tax basis in the business can significantly increase, leading to a bigger QSBS exclusion when selling the shares.
Let’s illustrate this:
Corporate Formation Scenario: Two founders set up a Delaware C corporation. Both get 50% of the company stocks for a nominal amount. After six years, they sell their QSBS-qualified shares for $400 million. Their profits total ~$400 million, with only $20 million being tax-exempt (each founder has a $10 million gain exemption), leaving $380 million taxable.
LLC Conversion Scenario: The same founders form a Delaware LLC, taxed as a partnership. After some years, the LLC, now valued at $40 million, converts to a C corporation. Their new QSBS basis is a combined $40 million, which means $20 million for each founder. Five years post-conversion, they sell their shares for $400 million. Their total gains amount to ~$400 million, with only $40 million being taxable and the remaining $360 million being tax-exempt, due to each founder having a gain exemption of up to $200 million.
However, the LLC conversion strategy has its pitfalls. The QSBS’s five-year holding duration begins at the time of conversion, not when the business was originally established. And the conversion should happen before the company’s assets surpass the $50 million mark. Potential entrepreneurs should be aware of the complexities and intricacies involved and consult with tax experts accordingly.
Another intriguing strategy is the QSBS ‘stacking’ method. This method capitalizes on the principle that the more shareholders possessing QSBS in a company, the higher the collective QSBS gain exclusion. A typical approach to achieve this is by gifting QSBS to family members or certain trusts. However, this strategy isn’t foolproof, as the IRS may challenge its implementation, and there could be potential gift tax implications.
In summary, while most founders might opt for the traditional Delaware C corporation formation, being aware of these advanced strategies and consulting with professionals can unlock substantial tax benefits for those willing to navigate the complexities.
