If You Are An LLC, Consider Becoming a C Corporation Before Year End

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UPDATE: The fiscal cliff bill passed by Congress and signed by the President contains an extension of this Section 1202 tax break for investments made through the end of 2013. Therefore, you have until the end of calendar year 2013 to take advantage of this incentive. See this blog post: http://www.startuplawblog.com/2013/01/01/fiscal-cliff-bill-would-renew-100-exlusion-for-qsb-stock-investments/

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If you currently operate your business as an LLC taxed as a partnership, you may want to convert to a C corporation before year end.

Why?

Because if you acquire C corporation stock before the end of the year, and your business qualifies as a qualified small business under Section 1202 (in general, less than $50M in gross assets and not a service business), you may escape tax entirely on your ultimate sale of the stock. This exemption from capital gains taxes includes exemption from the alternative minimum tax. (There is an overall cap on the exclusion, but it is big–$10M.)

You will have to hold the stock for 5 years before sale, but if you hold it for less than 5 years before sale there is a deferral/rollover provision allowing you to reinvest in stock of another qualified small business and continue deferring your gain and working toward the 5 year holding period. There are other conditions as well.

  • This exemption is only available to individuals (but LLCs or partnerships holding QSB stock can pass through the benefit to their individual owners).
  • There is an overall cap on the gain exclusion equal to, in general, the greater of (A) $10M, or (B) 10 times the aggregate adjusted bases of the QSB stock disposed of during the taxable year.
  • The business has to be a qualified trade or business, which generally excludes service type businesses.
  • 80% of the value of the assets of the corporation have to be used in the active conduct of 1 or more qualified trade or businesses.

Many businesses which are currently organized as LLCs will meet these requirements, and if restructured as C corporations before the end of the year can take advantage of this tax exemption.

But this is a one time opportunity that only lasts until the end of the year.

You should consult your tax advisors to make sure you will be able to qualify and won’t trigger tax on the conversion of your LLC into a corporation, and that conversion otherwise makes sense (it is not right for everyone, and once you become a C corporation you can’t move back to an LLC form without paying a tax), but moving away from an LLC and moving into a C corporation structure before the end of the year may make sense for you.

You can find Section 1202 here.

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  • http://metaoptimize.com Joseph Turian

    Could you please elaborate on this sentence: “The business has to be a qualified trade or business, which generally excludes service type businesses.” ?

    What are the qualified types of business? What are not?

    • Anonymous

      Section 1202(e)(3) defines qualified trade or business as follows:

      (3) Qualified trade or business
      For purposes of this subsection, the term “qualified trade or business” means any trade or business other than—
      (A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
      (B) any banking, insurance, financing, leasing, investing, or similar business,
      (C) any farming business (including the business of raising or harvesting trees),
      (D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
      (E) any business of operating a hotel, motel, restaurant, or similar business.

  • Rob Mathewson

    Joe,
    Has today’s deal between Obama and the GOP extended the window of opportunity for a C corp conversion?

    • Anonymous

      Rob, I don’t believe that an extension was included, but I will be on the lookout to confirm.

  • John Cunningham

    LLC is a law term. C corp is a tax term. Under the Check-the-Box regs, an LLC can elect into Subchapter C for federal tax purposes and, under the laws of most states, for state tax purposes, while remaining an LLC for all law purposes.

    John Cunningham
    McLane Law Firm
    (603) 628-1315
    john.cunningham@mclane.com

    • Anonymous

      John, I don’t see why checking the box would not work. An LLC, if it checks the box to be taxed as a corporation, will be taxed as a C corporation–which is what 1202 requires.

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