Setting up an S Corporation? Watch Out How It Affects Your Founder Stock

S Corporations Founder Stock Benefit

If you are starting a business, be careful not to rush to set your company up as an S corporation without first considering the qualified small business stock benefit.

The reason: If you start out as an S corporation, then your founder’s stock will not qualify as “qualified small business stock” (QSBS) under Section 1202 of the Internal Revenue Code.

Section 1201, QSBS

Section 1201 QBSB

Under Section 1202, QSBS is stock in a C corporation if, as of the date of issuance, the corporation is a “qualified small business” (meaning a domestic corporation which is a C corporation with less than $50MM in gross assets both before and after the stock was issued) and, in general, which is acquired at its original issue in exchange for money or other property or as compensation for services. Thus, if you form your startup as an S corporation, your founder stock cannot qualify as QSBS. This can be a very painful and costly mistake.

Section 1202 has other requirements as well.

At least 80 percent of the assets of the corporation have to be used in the active conduct of one ore more qualified trades or business. In general, a “qualified trade or business” means a business other than a services business in the fields of health, law, engineering, architecture, accounting, actuarial science, brokerage services, or any trade or business where the principal asset is the reputation or skill of 1 or more of its employees. Banking, insurance, financing, leasing, investing and similar businesses are also excluded, as well as farming businesses, and operating hotels, motels, restaurants, or similar businesses. In addition, stock in a corporation shall not be treated as QSBS stock unless during substantially all of the taxpayer’s holding period for such stock, the corporation met the active business requirements and such corporation was a C corporation.

Despite all of these carveouts and limitations, the QSBS exemption is widely available. Technology companies are typically going to qualify for the benefit.

Benefit of Founder Stock Qualifying as QSBS

Benefit of Founder Stock Qualifying as QSBS

What is the benefit of having your founder stock qualify as QSBS?

If you hold QSBS for more than 5 years, there is no federal tax on up to $10 million in gain on the sale of the stock. None. No federal income tax. No alternative minimum tax either. This is a big deal. This could save you about $2.38MM in federal income tax, or more if you are subject to state income tax. Imagine if you missed out on this because you never thought or were told about it?

We have run into a number of founders who have regretted not forming their companies as C corporations at the outset. We had one client that originally formed his company as an LLC taxed as a partnership, then about 18 months later converted it to a corporation when he raised money from VCs.

Four years after that, they sold the company for a lot of gain. Under 1202, you can’t tack periods in which you were not a C corporation. Thus, he could only count the 4 years, and he didn’t have 5 in. If he had just started his corporation as a C corporation, then he would have been able to access the QSBS benefit and save a lot in taxes.

Ouch.

(By the way, if you don’t have your 5 years in, there is the opportunity to rollover gain under Section 1045 of the IRC, but the details of 1045 are for another post.)

Startup Law Advice

Startup Law Advice

Thus, our advice is to think carefully about the potential Section 1202 benefit when you form your company. Don’t rush in to S corporation status.

Now, this isn’t to say an S corporation is always a bad choice — it may not be. It really depends on your personal circumstances, plans, etc. If you are planning to invest a substantial amount of money into your startup, the pass through of the losses might have a lot of present value. And the present value of those losses might exceed the discounted potential future value of the QSBS benefit — based on your estimates of exit scenarios, etc. But it also might be that you don’t plan to put a lot of your own cash in the business — thus the benefit of the pass through of the losses might be de minimis and for it you would have given up the 1202 benefit.

Make an informed choice though, after considering all of this.

Brandon and Joe

Brandon Nett is the Managing Director at Anderson Tax. Brandon is an experienced transaction focused CPA serving start-up and VC backed organizations in the Pacific Northwest. He creates value through efficient tax structuring of investments and start-ups, supporting periods of high growth and rapid change with balanced and practical tax advice and guidance, and assisting all stakeholders in understanding and optimizing tax matters from start-up through exit. Connect with Brandon on LinkedIn.

Joe Wallin is a leading startup lawyer in the Pacific Northwest and the founder of the Law of Startups. He represents companies from inception to exit, as well as investors, executives, and founders. His practice focuses on startups and emerging companies, angel and venture financing, and M&A transactions. Follow him on Twitter @joewallin