Risk and Reward: How Starting Your Business as an LLC Could Impact QSBS Tax Savings

As a founder, deciding whether to organize your business as a corporation or a limited liability company (LLC) is a crucial first step. Corporations are often favored for their ability to attract venture capital and offer qualified small business stock (QSBS) benefits, among other factors. Thus, many founders default to the corporate structure from the start. However, in doing so, the founder may be forfeiting some potentially significant tax advantages offered by an LLC (or other entity taxed as a flow-through). The QSBS tax benefits are one example of this.

Understanding QSBS Benefits

The QSBS rules allow individual shareholders of a U.S. corporation engaged in a qualifying business to exclude a significant portion of their gain from the sale of stock held for more than five years from federal income tax, potentially up to 100 percent. This exclusion applies to gains up to the greater of $10 million or ten times (10x) the taxpayer’s basis in the stock. For most founders who organize their businesses as corporations from the start and do not make significant capital contributions, this rule would generally cap the amount of such founder’s tax-free gain at $10 million (with any additional gain typically taxed at regular capital gain rates).    

This is where the use of an LLC can have a significant impact. If a business begins as an LLC rather than a corporation but subsequently converts to corporate status, some interesting QSBS rules come into play. Specifically, for purposes of the 10x basis limitation, a founder’s basis in the shares of the corporation received on the conversion is based on the fair market value of the founder’s interest in the business at the time of conversion. In other words, if the fair market value of the founder’s interest in the business is more than $1 million at the time of conversion, their QSBS tax benefit limit under the 10x basis limitation will be greater than the $10 million limitation which might otherwise apply. 

Strategic Timing for Conversion

Thus, one potential strategy is for a business to start as an LLC rather than a corporation. Once the business has grown in value, the LLC could be converted to a corporation, thereby increasing potential QSBS benefits. Depending on the circumstances, this approach can significantly increase the QSBS 10x basis limitation, allowing founders to exclude more gain from taxes upon selling their shares.

Illustrating the Benefits

Consider this scenario: a founder starts a business as an LLC with an initial investment of $1,000. Over time, the business grows, and the founder’s interest in the business is valued at $20 million. If the founder were to convert the LLC at this point, the founder’s basis for QSBS purposes in the shares of the converted corporation would be $20 million. Therefore, the founder would be eligible to exclude up to $200 million of gain (10x $20 million) on a subsequent sale of stock, rather than just $10 million (the amount that would have been excluded if the business had started as a corporation).

Potential Risks and Considerations

While this strategy can be highly beneficial, it comes with risks. For one, any “built-in” gain accrued before converting from an LLC to a corporation is not eligible for the QSBS exclusion and will generally be taxed at regular capital gain rates. This means that a founder could instead realize less QSBS benefit in the end if the price at which they sell their shares is not high enough. For example, if the founder in the illustration above received $25 million of proceeds in an exit transaction, the founder’s tax-free gain would be $5 million under the LLC-to-corporation conversion strategy, but $10 million had the founder started the business as a corporation. In general, a founder’s interest in the business needs to appreciate by more than $10 million after the LLC-to-corporation conversion for the LLC structure to produce enhanced QSBS benefits. 

Additionally, to qualify for QSBS, the fair market value of the entire business (not just the value of the founder’s interest) at conversion must not exceed $50 million, inclusive of any cash raised from investors as part of such conversion (for example, if the conversion is done in connection with a financing round). It’s also important to keep in mind that the five-year holding period for QSBS starts only upon conversion to a corporation.

Finally, founders should note that starting as an LLC and converting to a corporation is likely to result in additional legal and accounting fees as compared to simply beginning as a corporation. Furthermore, the flow-through tax treatment of LLCs may be unfamiliar to equity holders of the business.

Conclusion

Organizing a new business as a corporation from the start is often viewed as the most expedient and cost-efficient structure for founders and their new ventures. However, founders should consider the LLC format, at least in the initial stages. Starting as an LLC and converting to a corporation at a later time can offer substantial tax advantages under QSBS rules, but it also requires careful planning and timing and comes with certain risks. It is essential to work closely with tax advisors to navigate these complexities and maximize potential tax savings.