Conversions for QSBS Status: Best practices for restructuring LLCs taxed as S-Corporations

Qualified Small Business Stock (QSBS) provides a tax benefit for eligible shareholders to exclude up to $10 million of capital gains (or 10 times their basis) on the sale of stock held over five years. However, only companies taxed as C-corporations can issue shares that may meet the requirements for QSBS.

A business taxed either as a passthrough entity (i.e. a partnership or S-corporation) or as a disregarded entity (i.e. a single-member LLC) must convert to a C-corporation before it can offer QSBS. A limited liability company (LLC) is a flexible business entity for tax classification purposes.

By default, a single-member LLC is disregarded for tax purposes and a multi-member LLC is classified as a partnership. However, an LLC can affirmatively elect to be treated either as an S-corporation or a C-corporation for tax purposes.

In this article, we’ll explore the process, potential benefits, and common pitfalls of converting a pass-through entity into a corporation eligible to issue QSBS, specifically for LLCs taxed as S corporations.

This article was written in collaboration with Hanson Bridgett LLP.

What makes a small business “qualified” for QSBS?

C-corporations are subject to “double tax” at the entity and shareholder level, unlike passthrough entities such as LLCs taxed as partnerships or S-corporations. With the federal corporate tax rate capped at 21% under the Tax Cuts and Jobs Act of 2017 and the potential for valuable QSBS savings for shareholders, classification as a C-corporation can be advantageous for many operating companies.

 For purposes of the exclusion, the requirements for a qualified small business (QSB) include:

•  The company must be taxed as a C-corporation.

• The company must have had aggregate gross assets of $50 million or less at all times before and immediately after the equity was issued.

• At least 80% of a company’s assets must be actively used in a qualified trade or business for substantially all of the taxpayer’s holding period.

Original issuance requirement

In addition to the QSB requirements above, there is an original issuance requirement for QSBS. Unless an exception applies, shares in the QSB must be directly issued from the corporation in exchange for cash, property (other than stock), or as compensation for services. Stock-for-stock exchanges may only qualify in certain circumstances when the exchanged stock itself is QSBS.

→ Read the full QSBS requirements and learn more about QSBS

Carta conducts in-depth QSBS eligibility reviews to identify exactly which of your company’s shares may be QSBS-eligible. Combine Carta’s QSBS Attestation with tax structuring advice from Hanson Bridgett to maximize your QSBS tax benefits.

Leto v. United States: How restructuring missteps can disqualify issuances as QSBS

A recent court case, Leto v. United States,¹ illustrates how a lack of tax planning in business restructuring can easily lead to disqualification from QSBS status.

Background

The taxpayer in the case, Michael R. Leto, originally held membership interests in GlobalTranz Enterprises, LLC, formed under the state law of Arizona as an LLC and elected to be taxed as an S-corporation. To convert from a passthrough years later, GlobalTranz Enterprises, Inc., was incorporated in Delaware and did not make the S-election. The LLC and C-corporation merged, dissolving the LLC and exchanging Leto’s LLC interests for shares in the newly formed C-corporation.

More than five years later, Leto sold his shares in the C-corporation GlobalTranz Enterprises, Inc. While he did not exclude capital gain on his original return, Leto later amended to request a refund on the basis of a partial exclusion for the sale of QSBS. The IRS and the U.S. District Court, however, denied this claim due to the poorly planned transition of the GlobalTranz business from an S-corporation to a C-corporation.

The issue and court ruling

 The key issue was whether Leto’s newly issued stock in the C-corporation met the original issuance requirement to be eligible for QSBS. According to the IRS, when the LLC elected to be taxed as an S-corporation, its membership interests were considered “stock” for federal tax purposes.

The District Court agreed, determining that this exchange of the S-corporation "stock" in GlobalTranz Enterprises, LLC, for C-corporation stock in GlobalTranz Enterprises, Inc., did not meet the "original issuance" requirement under Section 1202. As a result, the government’s motion to dismiss was granted because Leto was not entitled to the QSBS exclusion.

Converting LLCs with S-corporation status: Potential paths to QSBS

With proper planning, similarly situated taxpayers can preserve QSBS benefits under Section 1202. One of the primary structuring missteps in the Leto case was the stock-for-stock exchange during the transition from an LLC taxed as an S-corporation to a C-corporation.

Contribution of assets for stock

In a tax-deferred transfer to a controlled corporation under Section 351, the result could have been different for Leto. GlobalTranz Enterprises, LLC, could have contributed property (assets) to the new C-corporation in exchange for stock—instead of merging into it.

For the transaction to qualify for tax deferral under Section 351, the transferors must be in control of at least 80% of the voting power and 80% of the shares of the C-corporation’s stock immediately after the exchange. The final structure would be two-tiered, with the LLC taxed as an S-corporation controlling shares in the C-corporation as its operating subsidiary.

In contrast to Leto’s conversion, this restructuring approach would meet the original issuance requirement for QSBS purposes because the corporation would be issuing shares in exchange for property. Assuming the assets exchanged are valued at no more than $50 million at the time of contribution, the original LLC members could potentially benefit from capital gain exclusion upon a future sale of the C-corporation’s stock.

While this is a relatively straightforward approach, it can be difficult to implement in practical terms when the LLC employs a large team or holds contracts, licenses, or other business assets that cannot be readily assigned to a newly formed entity. These complexities can be especially challenging for a company with significant operations and relationships prior to the restructuring.    

F-reorganization

To preserve continuity for ongoing agreements, payroll, and other reporting or legal arrangements, an alternative path forward for GlobalTranz Enterprises, LLC’s QSBS eligibility would have been an F-reorganization under Section 368. As with Section 351, Section 368 allows for tax deferral if properly planned but allows the operating entity to maintain all its preexisting contracts, EIN, and registrations without disruption.

An F-reorganization of an LLC taxed as an S-corporation involves several key steps: 

1. A new holding company is formed with stock issued to the LLC members in exchange for all the membership interests.

2. The new holding company files an election with the IRS to treat the LLC as a qualified subchapter S-subsidiary (Q-sub) effective as of the transfer.

3. The new holding company automatically inherits the former S-corporation status of the LLC subsidiary.

4. A new C-corporation is formed with the contribution of all the membership interests in the LLC from the new holding company in exchange for stock.  

5. The transfer of the LLC as a disregarded entity is treated as a contribution of assets for stock, meeting the original issuance requirements.

The final result is a three-tiered structure where the new S-corporation holding company (NewCo) owns 100% of the C-corporation, which in turn holds the original operating LLC as a disregarded entity. In contrast to the former approach under Section 351, there is no disruption in the legal continuity of the LLC and no need to move assets or employees over to a new entity under an F-reorganization under Section 368.

Following these reorganization steps may have set up Leto’s NewCo to claim QSBS eligible gain exclusion on the sale of C-corporation shares after five years. In both scenarios, any allocable gain exclusion under Section 1202 would pass through to the S-corporation shareholders via a Schedule K-1.

How Carta and Hanson Bridgett can help prevent QSBS disqualification

QSBS eligibility can be complex, but timely planning and documentation can make all the difference. Companies using Carta can benefit from real-time QSBS tracking and reporting, ensuring compliance throughout the business lifecycle. Carta’s platform helps founders, early employees, and investors determine which shares qualify for QSBS benefits and whether they’ve met the required holding period.

Working alongside legal experts at Hanson Bridgett, Carta provides essential support for companies navigating complex transactions. Through a combination of QSBS attestation services and tax structuring advice, Carta and Hanson Bridgett help businesses minimize risk and preserve key tax benefits. In scenarios similar to Leto v. U.S., this type of guidance can ensure compliance and protect valuable tax exclusions for shareholders in a future exit.

¹ Leto v. United States, No. CV-20-02180-PHX-DWL (D. Ariz. 2022)