Potential Tax Advantages for Investors in a C Corporation

Entrepreneurs often struggle with deciding whether to structure their business as a C corporation or a pass-through entity. In the past, most small and mid-sized businesses were established as a pass-through entity, a structure that transmits tax liability to the owner. Typical pass-through entities include sole proprietorships, partnerships and S corporations.

However, the tax landscape changed with passage of the Tax Cuts and Jobs Act (TCJA). Beginning with tax years 2018 and beyond, it reduced the corporate tax rate from 35% to 21%, thus making the C corporation structure more attractive.

C corporations also are attractive to business owners seeking venture capital funding. Sections 1202 and 1045 of the Internal Revenue Code (IRC) apply to investors in C corporations whose shares comprise qualified small business stock (QSBS) which are issued by a qualified small business (QSB) on or after August 10, 1993. The C corporation’s aggregate gross assets must not exceed $50 million when the QSBS is issued or immediately afterward (including the issuance amount received). The IRS also requires that 80% of the C corporation’s assets must be actively used to conduct trade or business. To qualify as QSBS, the business entity also must be a C corporation on the date of issuance. This requirement disallows an S corporation from converting to a C corporation to gain tax advantages.

Under IRC Section 1202, investors or other non-corporate shareholders may be able to permanently exclude from taxation some or all of the gain realized on the sale of the QSBS. The capital gain eligible for exclusion is limited to either $10 million or 10 times the investor’s basis of the stock, whichever is greater. The investor must hold the QSBS for more than five years to qualify.

If this requirement is not met, IRC Section 1045 provides an alternative to investors who sell their QSBS after holding it for at least six months. They can defer taxation on the gain if they reinvest the proceeds in replacement QSBS within 60 days of the sale. The amount of the deferred gain will reduce the basis in the replacement QSBS.

Entrepreneurs should consider the advantage of IRC Sections 1202 and 1045 when choosing the proper business structure in the startup phase. These regulations can significantly impact plans for venture capital funding and the execution of an exit strategy.

If you have any questions about this please contact your ALL tax advisor or call us at 617-738-5200.

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