By: Cheryl Heusser

It used to be that when tech start-up companies would face the question of entity selection, pass-through entities such as LLC’s made a lot of sense because of high corporate income tax rates and double-taxation of C corporations. Overall tax savings of LLCs could be 10% or more, just for Federal taxes. With the passage of the Tax Cuts and Jobs Act last year and income tax rate reductions in C corporations, some businesses may find that corporations may now provide longer-term tax benefits because of Section 1202 and qualified small business stock (QSBS).

Section 1202 provides guidance on QSBS. If certain criteria are met, gains (up to certain limits) related to the sale of QSBS may be excluded up to 100% from income, either reducing or eliminating double taxation of income, depending on the type of sale.

In order for the stock to qualify as QSBS, certain requirements must be met:

• The stock must be held inside a C corporation;
• The corporation must meet the requirements of being an active “qualified trade or business,” as defined within Section 1202;
• On the date of stock issuance, the corporation must have gross assets of less than $50 million and immediately after the issuance, the corporation’s gross assets must be less than $50 million;
• The holder of the stock must be the individual or entity of original stock issuance; and
• The taxpayer must hold the stock for at least five years.

The requirements sound simplistic, but each requirement has its own nuances that must be carefully considered to ensure QSBS compliance.

When doing a side-by-side comparison of the tax effects of choosing a pass-through entity structure versus a corporate structure, the benefits of corporations with 1202 stock make the most sense when:

• The C corporation will meet the active qualified trade or business requirements;
• It is clear that the holding period of a majority of the stockholders will be more than five years, making them eligible to exclude gain;
• A majority of the stockholders’ stock qualifies as QSB stock so they can take advantage of the gain exclusion;
• There is an expectation of large corporate growth and ultimate sale of stock or assets, causing a large gain that would either lead to an exclusion of some or all of the gain entirely (in the case of a stock sale) or lead to an exclusion of some or all of gain from double taxation (in the case of an asset sale); and
• At least some of the annual corporate profits are retained and reinvested in company growth so that there is no double taxation during years of operation.

There are always other intangible reasons why business-owners may need to choose one entity structure over another. However, with all other things being equal and with the reduction of corporate income tax rates, C corporations have certainly become a contender.

It may be time to (re)examine the pros and cons of different entity structures based on your current situation. Please contact your Snyder Cohn point of contact to discuss further.