One reason why a startup may prefer to organize the business entity as a corporation is that venture capital investors tend to be more familiar and comfortable with receiving stock as opposed to LLC interests. The Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) added another reason to organize as a C corporation: permanent extension of the 100% exclusion for eligible gain on sales of qualified small business stock (“QSBS”).
Generally under Section 1202 of the Internal Revenue Code as amended, an individual shareholder who acquired QSBS after September 27, 2010 and held the QSBS for more than five years is eligible for 100% exclusion of eligible gain realized on disposition of the QSBS (a partial exclusion is allowed for QSBS acquired after August 10, 1993 and on or before September 27, 2010). The 100% exclusion applies for purposes of both the regular and the alternative minimum tax.
Qualified Small Business Stock
QSBS means any stock in a C corporation constituting a “qualified small business,” which is originally issued after August 10, 1993 in exchange for money, property (other than stock), or services. If the stock is not originally issued but is acquired from another person, the stock may qualify as QSBS if it is acquired in a nonrecognition transaction from a transferor meeting these requirements. Essentially, this means a secondary purchaser of stock will not qualify for QSBS benefits.
A qualified small business is a corporation that meets the following requirements:
- It is a domestic corporation that has been a C corporation for substantially all of the taxpayer’s holding period.
- The aggregate gross assets of the corporation at all times from August 10, 1993 until immediately after the issuance of the taxpayer’s stock do not exceed $50 million. For this purpose, a corporation’s aggregate gross assets are equivalent to its cash (including any cash contributed in connection with the current issuance) plus the aggregate adjusted bases of other property held by the corporation.
- During substantially all of the taxpayer’s holding period for the stock, at least 80 percent of the corporation’s assets have been used in the active conduct of a trade or business other than certain categories such as professional services, banking/insurance and finance businesses, farming, mining and hospitality.
Annual limitation on gain exclusion
The benefit under Section 1202 is not unlimited. The amount of gain that a taxpayer may exclude under Section 1202 from the disposition of QSBS in any corporation is limited to the greater of: $10 million or 10 times the taxpayer’s basis in the QSBS of that corporation which was disposed during the year. For example, for founder stock acquired at initial formation with cash investment of $100,000, the gain exclusion limit would be $10 million because that is greater than 10 times the basis which is only $1 million. If later the founder or an investor is issued stock for an investment of $3 million (and the stock qualifies as QSBS because, for example, the corporation’s aggregate gross assets do not exceed $50 million), the potential amount of gain exclusion on a later disposition of that stock would be $30 million.
Considering the current maximum capital gains rate of 20% and the additional 3.8% net investment income tax, founders and investors will need to pay attention to the benefits of entity and investment structuring to qualify for gain exclusion under Section 1202.
For an investor that is a nonresident individual, Section 1202 will be only a secondary provision because nonresident aliens generally are not subject to U.S. federal income tax on gains from stock in a U.S. corporation in the first place. In the case of investment by a nonresident individual (or foreign corporation), the structure may be optimized based on considerations of both U.S. and foreign tax laws.