Can An S Corporation Issue Qualified Small Business Stock?

Q&AI am the founder of a company.  If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?

Answer:

Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*

No.  “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’”  A “qualified small business” means a C corporation.

What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).

If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however.  The reason for this?  Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.”  But shares received while the company was an S corporation cannot qualify.

The answer is different if you are currently an LLC and you incorporate.  If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.

* For more information on Section 1202 generally, please see this blog post:  startuplawblog.com/section-1202-qualified-small-business-stock 

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About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • anonymous reader

    But can’t the founder issue himself more shares after the conversion to a C corp? Assuming that there are no outside investors to complicate things, the C corp can issue additional shares to all founders and those new shares would get the favorable tax treatment, correct?

    • http://startuplawblog.com/joewallin Joe Wallin

      Maybe, yeah. But those shares might cost quite a bit from a tax perspective to get in the hands of the founder.

  • Guest

    What section of 1202 applies to “If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit”?

    • http://startuplawblog.com/joewallin Joe Wallin

      There is no specific provision which says exactly that. But you can meet the various requirements of section 1202 when you incorporate an llc taxed as a partnership.

      • Robina

        Joe – I haven’t been able to find anything that specifically addresses this item but have found articles making the same statements. Am I correct to presume it qualifies based upon meeting the requirements when incorporated and the fact it was previously an llc has zero bearing on the situation. It would be nice to be able to provide something authoritative to support the position.

        • http://startuplawblog.com/joewallin Joe Wallin

          Correct. If you have an LLC taxed as a partnership, it is possible to incorporate the LLC in way that will technically satisfy the requirements of Section 1202. See Section 1202(c).