Before you initially balk at the post title, the answer is “yes, S corps do not qualify for Section 1202 as it relates to Qualified Small Business Stock (QSBS)”. However, initially starting your business as an S corp and later converting to a C corp can offer significant benefits, particularly in relation to QSBS. Here is a detailed explanation of the benefits and rationale behind this lesser known “S corp QSBS” tax strategy:

Initial Tax Benefits of S Corps Compared to C Corps

1. Pass-Through Taxation: S corps offer pass-through taxation, meaning the income, deductions, and credits pass through to the shareholders and are reported on the owner’s individual tax returns. This avoids the double taxation typically associated with C corps (where profit is first taxed at the corporate level (currently 21%) and again at the shareholder level when distributed as dividends or payroll).
2. Simplicity and Lower Administrative Costs: Operating as an S corp is often simpler and less expensive in terms of administrative burden and regulatory compliance compared to a C corp.
3. Attracting Investment: Some investors prefer the pass-through taxation of S corps, especially if can benefit from the direct allocation of losses or tax credits on their personal tax returns.

Initial Tax Benefits of S Corps Compared to an LLC or Partnership

1. Reduction/Avoidance of the Self-Employment Tax: One of the primary benefits of an S corp compared to an LLC or partnership is the lack of self-employment tax on business profits. If you use a similar strategy, but start as an LLC or partnership, any business profits would be subject to self-employment tax (approximately 14.13% of business profits). If you start as an S corp, you would only have to pay FICA and payroll-related taxes on your reasonable salary, rather than full business profits.
2. Recordkeeping Simplicity: Partnerships and multi-member LLCs allow for special allocations when it comes to apportioning income and expenses between partners. This makes internal recordkeeping more complicated than S corps which are allocated on a simple pro-rata basis. This includes allocating payroll and bonuses for partners, where S corps can simply pay its shareholders via payroll.

What is QSBS and What Makes it so Beneficial

QSBS refers to shares issued by small business corporations and qualify for favorable tax treatment under Section 1202 of the Internal Revenue Code. The primary benefit is that, if eligible, shareholders can exclude the greater of $10 million or 10 times the adjusted basis in the stock of capital gains at time of sale. If your initial basis in the stock is $5 million, you could potentially exclude up to $50 million in capital gains for federal income tax purposes!

Requirements and Eligibility for QSBS Treatment

1. Stock must be issued by a domestic C corporation.
2. The corporation may have no more than $50 million of gross assets at time of issuance.
3. At least 80% of the corporation’s assets must be used in an active, qualified trade or business. Certain businesses, such as professional services, hospitality, and the financial sector are excluded.
4. The stock must be acquired at its original issue, directly from the corporation. It cannot be transferred or received as compensation for services provided to the corporation.
5. The stock must be held for more than 5 years to be eligible for the tax benefits.

Strategic Timing of Reorganization

By starting as an S corp for QSBS purposes and later converting to a C corp at a strategic point, the company can take advantage of an increased adjusted basis in the stock (obtained during the period the business was an S corp) and utilize the 10x multiple to exclude larger capital gains than the $10 million base. Under IRS Sec. 1202(d)(2)(B), the adjusted basis in the stock would be equal to the fair market value of the business at time of conversion, not the historical tax basis.

Here’s An Example of the S Corp QSBS Tax Strategy 

In 2015, Founder A organized ABC Company as an LLC and then elected the business to be taxed as an S corp. Founder A contributed $1 in exchange for 90 shares (90%) of the company. In 2017, ABC Company took on an outside investment and Founder A’s 90 shares were now valued at $4 million dollars. Immediately after the investment, ABC Company converted into a C corporation and exchanged the S corp shares worth $4 million for C corp stock. In 2023, Founder A sold the C corp stock for $36 million (a gain of $32 million). Since Founder A held the C corp shares for over 5 years (the period in which the business was an S corp does not count towards the 5 year QSBS requirement), they are able to exclude the greater of $10 million or 10x their adjusted basis (10 * $4 million = $40 million). Since their initial gain of $32 million is less than 10 times their adjusted basis ($40 million), they are able to exclude the entire gain on sale. However, Founder A would have to pay tax on the initial increase in value from the S corp exchange (4 million less the initial contribution of $1). In this situation, Founder A would only pay long-term capital gains tax on the increase in the S corp value ($3,999,999). The remainder would be excluded.

Complexities of Converting an S Corp vs a Multi-Member LLC

From an administration standpoint, converting from an LLC to a C corporation is relatively simple. There is a “check-the-box” election that is made to convert to a multi-member LLC to a C corporation. This simple election is made on Form 8832 to be treated as a C corporation for tax purposes. Converting from an S corporation to a C corporation is a bit more complex. A check-the-box election is not available for S corporations, but rather an attorney would need to restructure the entities via an “F-reorganization” or assets will need to be transferred from the S corporation to a new entity that is taxed as a C corporation. The IRS could disallow a restructuring if it was only completed to qualify for QSBS and should have a valid business purpose.

When the S Corp QSBS Strategy Makes Sense

This was a ton of information, so let’s try to simplify it. When does the S corp QSBS tax strategy make sense? If you meet the following criteria, this strategy may make sense for your business:

1. The S corporation is going to be profitable and will make over $100k a year.
2. The S corporation is going to be in business for a handful of years so that the tax savings on self-employment tax will outweigh the attorney costs to complete the conversion.
3. The tax savings from the QSBS will outweigh the additional taxes paid for being taxed as a C corp (rather than S corp) for 5+ years.
4. The value of the founder’s shares (based on valuation or outside investment) is greater than $1 million dollars.
5. The founder plans to sell the business for more than $10 million dollars.
6. The founder plans to sell the business in more than 5 years from point of conversion.