One big beautiful exclusion: exploring the benefits of the section 1202 exclusion for start-ups

“Venture creation is a complex, non-routine process, which involves interaction among various agents (individuals, partners, groups, parent organizations, etc.) and the business environment.” (Li and Dutta, 2018, p. 3). Consequently, choosing the appropriate legal entity for a start-up enterprise should be near the top of the hierarchy of decisions. Start-ups that begin informally with an idea and a modest amount of invested capital should expeditiously organize the business in a legal entity for many reasons, including: liability protection, providing an organized system of accounting, administering payroll, and generally providing a legal framework for corporate governance and taxation. Often, the analysis required in the decision-making process for the choice of the appropriate legal entity is an afterthought.

In the United States, organizing a legal entity is a state law matter rather than a federal matter. Common choices in the United States that allow for limited liability for the owners are a corporation, a limited liability company (“LLC”), a limited partnership (“LP”), and a limited liability partnership (“LLP”). Although organizing the legal entity is a matter of state law, federal tax law is often the driver for the ultimate decision regarding the type of legal entity. State tax law also plays a role, but typically the driver for the decision initially involves understanding the federal tax implications of the various types of legal entities.

The decision-making process can be a difficult task in the technical sense as well as requiring foresight and judgment. Most publicly available commentary is written with the tax professional in mind. This article is directed to entrepreneurs. It will generally discuss the tax consequences of entities that offer liability protection for their owners and explore the tax benefits of organizing the start-up as a corporation under state law, and more specifically, a qualified C corporation to capture the tax benefits of Internal Revenue Code (“I.R.C.”) section 1202. Recent federal tax law changes have enhanced the tax benefits for the shareholders of qualified C corporations that can be realized at the time of exit. This article will discuss the advantages and disadvantages of organizing the entity as a C corporation and qualifying for the exclusion of shareholder-realized gain upon the disposition of stock under I.R.C. section 1202.

It should be noted that each individual start-up requires situation-specific input; the authors do not advocate for one form of entity structure over another. This article will only discuss federal taxation. State taxation will vary among states and is beyond the scope of this article.

From an historical perspective, in the United States, LLCs are relatively new. Corporations, on the other hand, have existed in the United States since the colonial period (Hamil, 1998, p. 1485). During the early colonial period, corporations were granted charters from the King of England, and subsequently, the power to grant corporate charters was vested at the colony level, but still under the authority of the King (Hamil, 1998, p. 1485). Corporate charters issued by a colony later served as the predicate for the American states to issue corporate charters (Hamil, 1998, p. 1485). During the Constitutional Convention of 1787, which was convened to draft the Constitution (replacing the Articles of Confederation), James Madison proposed that Congress have the authority to issue corporate charters, but this proposal failed to be adopted (Hamil, 1998, p. 1486). Nevertheless, in 1791, signed by President Washington Congress did charter a federal bank, the Bank of the United States (Hamil, 1998, p. 1487). The Bank of the United States survived until 1832, when President Jackson did not reissue the bank's charter (Hamil, 1998, p. 1494).

Unlike corporations, LLCs were first created in 1977 in the state of Wyoming (Hamil, 1998, p. 1460). The principal driver in the LLC creation was the desire for corporate-like legal liability protection with favorable tax treatment of single-level taxation afforded to partnerships and sole proprietorships. As discussed more fully below, corporations that are not S corporations (i.e., C corporations) result in double taxation, once at the corporate level and again at the shareholder level when a dividend is paid. Hamilton Brothers Oil Company, an independent oil company, led the effort to create an entity that offered both owner liability protection and favorable tax treatment (Hamil, 1998, pp. 1463–1469). The LLC concept was initially presented in 1975 to the state of Alaska but failed in the Alaska legislature (Hamil, 1998, pp. 1464–1465). It was then presented to the state of Wyoming and was enacted by the Wyoming legislature on March 4, 1977 (Hamil, 1998, p. 1465). Hamilton Brothers Oil Company requested a ruling from the I.R.S. to approve pass-through tax treatment (i.e. single-level taxation at the member level) for LLCs. After much correspondence and reluctance, the I.R.S. finally issued a favorable private letter ruling on November 14, 1980, approving the requested tax treatment (Hamil, 1998, p. 1467). By 1996, all states had enacted LLC legislation (Hamil, 1998, p. 1477). Connecticut, for example, enacted its LLC legislation in 1993.

Entrepreneurs often conflate corporations and LLCs. While both vehicles are organized under state law and both vehicles offer owners limited liability protection, they are very different creatures of state statutory law. A corporation and an LLC also present very different tax profiles (except if an LLC elects for tax purposes to be classified as a corporation as discussed more fully below). For example, under most state statutes, corporations are owned by shareholders with ownership represented by shares of stock. LLCs are owned by members with ownership typically only designated in the operating agreement (the LLC governing document) through member capital accounts with no share certificate designating ownership. The corporate management structure is more succinctly defined in the corporate bylaws, including a board of directors and corporate officers. The LLC management structure is more flexible, with or without including managing members, with or without officer titles, and with or without a board of managers.

The major difference between a corporation and an LLC resides in their tax treatment. For federal tax purposes, except for S corporations (discussed below), corporations are tax-paying entities. Income is generally subject to double taxation: once at the corporate level where corporate income is received or accrued and a second income tax at the shareholder level upon receipt by the shareholder of a dividend distribution. The double taxation feature is viewed as the principal disadvantage of a C corporation. On the other hand, LLCs are treated as partnerships for tax purposes. The income of an LLC is taxed only once at the member level as a pass-through to the members. An LLC is not a federal tax-paying entity. The LLC members are responsible for the income tax. Nevertheless, it should be noted that for federal tax purposes (and many states), an LLC that is an eligible entity can elect to be classified as a corporation (see Treas. Reg. section 301.7701-3) by filing federal Form 8832, “Entity Classification Election.” In addition, because LLCs are treated as partnerships for tax purposes, allocation of income and deductions among its members are afforded greater flexibility. It should also be noted that a domestic LLC (i.e., formed under the laws of a state of the United States), that does not elect corporate status for tax purposes, with a single member is treated as a disregarded entity for federal tax purposes. (Treas. Reg. section 301.7701-3(b)(1)(ii)).

In the above discussion, we made general references to C corporations and S corporations. The designation of a C corporation and an S is strictly a tax reference and is not a reference under state law. S corporation status is an election made by the shareholders. Under federal tax law, the election is made under I.R.C. section 1362 using Form 2553, “Election by a Small Business Corporation.” For state taxation, many states follow the federal election, while others have their own S election procedures and forms. C corporation is defined under the Internal Revenue Code as a corporation that is not an S corporation (I.R.C. section 1361(a)(2)). An S corporation generally does not incur or pay federal corporate income tax (there are two special exceptions, the built-in gains tax and the passive investment income tax). Income and deductions are passed through to the shareholder(s) and included on the shareholder(s)’ individual tax return on a pro rata ownership basis (I.R.C. section 1366). Considering the advantage of one level of taxation, one may question why all corporations do not elect S corporation status. The answer is that not all corporations are eligible for S corporation status. Corporations eligible for S corporation status cannot have more than 100 shareholders; only individuals, estates, and certain trusts can be shareholders; can only have one class of stock; and cannot have nonresident aliens as shareholders (I.R.C. section1361(b)(1)). Another significant answer is that sales of stock of S corporations do not qualify for the I.R.C. section 1202 exclusion discussed in this article below.

A domestic (i.e., formed under the laws of a state of the United States) limited liability company (“LLC”), a domestic limited partnership (“LP”), and a domestic limited liability partnership (“LLP”) all offer some form of limited liability for its members and partners. Except for the domestic single-member LLC, all are classified as partnerships for federal tax purposes. Partnership taxation allows for all income and deductions to pass through to its members or partners with a single level of taxation. All three can elect to be classified as a corporation for tax purposes.

The discussion below is intended as a general discussion only. The characteristics of these entities may differ among the states under their respective state statutes. Under most state laws, LPs must have at least one general partner who is responsible for the debts of the partnership. Limited partners are not responsible for the debts of the partnership. The general partner also assumes the management responsibility of the partnership. Limited partners generally have either no or very limited management authority. The members of an LLC and the partners of an LLP have no responsibility for the debts of the partnership. An LLC can have a single member or multiple members. An LLC can designate members as managing members or non-managing members. An LLP must have at least two partners. An LLP is generally managed by its partners unless management restrictions are provided in the partnership agreement (Crampton and DeSantis, 2025). Some states restrict LLPs to only professional or licensed organizations (such as doctors, attorneys, C.P.A.s, etc.) (Crampton and DeSantis, 2025). Generally, a partner in an LLP is protected from liability for the negligent acts of its partners (Crampton and DeSantis, 2025).

Despite the potential for double taxation, there are reasons for choosing the C corporation classification. Some of the reasons may include the desire for an initial public offering (“IPO”), strategic investors or private equity investors may prefer owning stock rather than a membership interest in an LLC, favorable treatment for fringe benefits, ineligibility to elect S status, and foreign investors reticence to file U.S. tax returns as a result of becoming a partner or member in an LLC, LP, or LLP. One of the more inviting incentives to choose C corporation status is due to the expansion of the tax benefits of I.R.C. section 1202, “Partial Exclusion for Gain from Certain Small Business Stock.” The federal 2025 Act (P.L. 119-21), commonly referred to as the “One Big Beautiful Bill Act,” (hereinafter “OBBBA”), enacted on July 4, 2025, greatly enhanced the tax benefits (i.e., gain exclusion) for taxpayers (other than a corporation) that sell or exchange C corporate stock.

I.R.S. section 1202 was initially enacted as part of the Revenue Reconciliation Act of 1993 effective for stock issued after August 10, 1993. The provision was enacted to provide incentives for taxpayers to invest in small businesses. (DeSanty, 2013.) The provision underwent several major revisions beginning in 2009, with significant revisions made in the Tax Cuts and Jobs Act of 2017. Most recently, OBBBA significantly expanded the benefits of I.R.C. 1202 effective for taxable years beginning after July 4, 2025. Generally, the OBBA revisions included increasing thresholds for eligibility, increasing the amount of gain exclusion, and modifications to holding periods (discussed more fully below) (Derewenda, 2025.).

There are very few Treasury Regulations or court cases that exist to amplify and interpret I.R.C. section 1202. Fortunately, the statutory language is explicit and lengthy. Nevertheless, questions have arisen regarding interpretation that has been the subject of public commentary. I.R.C. section 1202 is a complex tax provision with many strict requirements. This article will discuss the salient features of the tax provisions that are effective after the enactment of OBBBA. Discussions of the application of I.R.C. section 1202 to Empowerment Zone Businesses (I.R.C. section 1202(a)(2)) and short sales (I.R.C. section 1202(j)) are beyond the scope of this article.

A start-up's long-term business strategic planning should incorporate an exit plan for the founders. A future sale of the company that has appreciated in value will result in taxable gain. Diligent tax planning at the front-end of the life of the start-up is essential to help minimize the tax impact to the company and to the owners in the event of a future sale of the company. Front-end tax planning includes the choice of business entity. I.R.C. section 1202 permits a generous exclusion of gain recognition for eligible taxpayers (discussed in greater detail below) in the event of a sale of the company. The company, however, must be a C corporation at the time of the sale (discussed in greater detail below). OBBBA greatly expanded the amount of excludible gain.

I.R.C. section 1202 provides that eligible taxpayers can exclude a significant amount of gross income derived from the sale or exchange of “qualified small business stock” (defined below). This exclusion has been in existence since 1993 but has undergone several revisions and extensions throughout the years resulting in a statute layered with many effective dates and a complex statutory framework. OBBBA increased the benefits of the statute but added additional complexity that requires careful reading and study.

An eligible taxpayer is a taxpayer other than a C corporation (I.R.C. section 1202(a)(1)). Eligible taxpayers would therefore include individuals, estates, and trusts. I.R.C. section 1202(g) provides special rules for pass-through entities that hold an interest in stock that qualifies for the exclusion. A pass-through entity is defined as a partnership, an S corporation, a regulated investment company (mutual fund), and a common trust fund. (I.R.C. section 1202(g)(4)(A) - (D)). Individuals, estates, and trusts that hold an interest in a pass-through entity are entitled to exclude their allocable share of gain from the disposition of qualified small business stock by the pass-through entity (the same as though the individual, estate or trust held the stock directly). (I.R.C. section 1202(g)(1)). The individual, estate, or trust must have held its interest in the pass-through entity on the date the qualified small stock was acquired and at all times before the disposition of the stock. (I.R.C. 1202(g)(2)(B)).

Prior to the enactment of OBBBA, to be eligible to claim an exclusion from gross income, an eligible taxpayer must have held qualified small business stock for more than five years. OBBBA shortened the holding period from five years to three years but installed a three-tier holding period structure to determine the percentage of gain subject to exclusion. For federal tax purposes, gain from the disposition of property is defined as the excess of the amount realized (i.e. selling price less expenses of sale) over the adjusted tax basis (i.e., cost less adjustments including depreciation). (I.R.C. section 1001). The statute generally contemplates exclusion of gain from the sale of stock. Nevertheless, although not explicit, a shareholder should be entitled to an exclusion if a corporation sells its assets and makes a liquidating distribution to the shareholder. (Nitti, 2018). I.R.C. section 331 provides that “amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock.” (I.R.C. section 331(a)).

Under OBBBA, for stock held at least three years, 50% of the gain is excludible; for stock held at least 4 years, 75% of the gain is excludible; and for stock held at five years or more, 100% of the gain is excludible. (I.R.C. section 1202(a)(5).) Prior to OBBBA, 50% of the gain is excludible for stock acquired after August 10, 1993, and before February 17, 2009, for stock held for more than five years. For stock acquired after February 17, 2009, and on or before September 27, 2010, 75% of the gain is excludible for stock held for more than five years. For stock acquired after September 27, 2010, and on or before July 4, 2025, 100% of the gain is excludible for stock held for more than five years. (I.R.C. section 1202(a)(3), Melton and Brown, 2025). OBBBA did not modify the above rules. Therefore, “section 1202 now effectively includes two sets of rules: one for stock acquired on or before July 4, 2025 (i.e. the old rules) and another for stock acquired after that date (i.e. the new rules).” (Melton and Brown, 2025).

The amount of gain excludible from gross income is limited under the per-issuer limitation. Under OBBBA, for taxable years beginning after July 4, 2025, eligible taxpayers can exclude “eligible gain” for one or more dispositions of C corporation stock issued by such C corporation. For taxable years after July 4, 2025, “eligible gain” is defined as gain from the sale or exchange of qualified small business stock held for at least three years and more than five years for stock acquired on or before July 4, 2025. (I.R.C. section 1202(b)(2)). Under the per-issuer limitation, the amount of excludible gain is equal to the greater of (1) the “applicable dollar limit” for the taxable year, or (2) ten times the aggregate adjusted bases of qualified business stock issued by the C corporation that was disposed of during the taxable year. (I.R.C. sections 1202(b)(1), 1202(b)(1)(A) and 1202(b)(1)(B)).

The “applicable dollar limit” is $10,000,000 for stock acquired on or before July 4, 2025 (reduced by the aggregate amount of eligible gain taken into account in prior taxable years), and $15,000,000 for stock acquired after July 4, 2025 (reduced by the aggregate amount of eligible gain taken into account in prior taxable years). (I.R.C. section 1202(b)(4)(A) and (B)). Therefore, OBBBA increased the dollar limit of the per-issuer limit of the exclusion from $10,000,000 to $15,000,000 for stock acquired after July 4, 2025. OBBBA did not modify the second prong (the ten times aggregate adjusted bases). Further, under OBBBA, the $15,000,000 exclusion amount will be adjusted for inflation for any taxable year beginning after 2026. (I.R.C. section 1202(b)(5)). The above limits are one-half of the respective amounts for taxpayers filing as married separately. (I.R.C. section 1202(b)(3)).

In addition to a complex, rule-ridden statute, one particularly confusing aspect is the placement and utilization of the phrases, “stock held” and “stock acquired” that appear throughout I.R.C. section 1202. These are threshold phrases that determine whether a taxpayer is eligible for the benefits of I.R.C. section 1202 as well as the amount of the exclusion. In either case, the stock must be original issue stock as discussed below. OBBBA seems to have magnified the confusion. With respect to the distinction between the starting date for “stock held” versus “stock acquired,” in a well-researched and thought-provoking article, one commentator conjectures that “Congress seems to have used language that is far too broad if its intent was to maintain the existing framework of Section 1202.” (Melton and Brown, 2025). The specific issue is to distinguish the beginning of the holding period of the stock from the acquisition date of the stock. Under federal tax law, in certain cases, the holding period may include the holding period of property that was received in a non-taxable event. (referred to as “tacking”) (I.R.C. section 1223). Such a property is generally termed a “carryover or substituted basis property.” “Stock held” generally includes the tacking period. Under pre-OBBBA, the delineation between the start date for “stock held” and the date for “stock acquired” was clear. “Stock held” was used in reference to the five-year period of time the stock must be held to qualify for the exclusion. “Stock acquired” was used in reference to the percentage of gain that is excludible from gross income and generally did not include the tacking period. OBBBA muddied the waters by adding I.R.C. section 1202(a)(6). This new subsection provides that for purposes of the entire I.R.C. section 1202, the acquisition date includes the first day the stock was “held” by the taxpayer, including the tacking period provided by I.R.C. section 1223. Hopefully, future regulations will sort out the confusion.

Not all dispositions of corporate stock qualify for the I.R.C. section 1202 exclusion. The stock must be “qualified small business stock.” Qualified small business stock is defined as “any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act [August 10, 1993] if as of the date of issuance, such corporation is a qualified small business [discussed below], and… such stock is acquired by the taxpayer at its original issue (directly or through an underwriter…” (I.R.C. section 1202(c)(1)(A) and (B)). The originally issued stock must be acquired in exchange for money or other property (except stock) or acquired as compensation for services provided to the issuing corporation (other than underwriting services). (I.R.C. section 1202(c)(B)(i) and (ii)).

If stock in a corporation was acquired solely through the conversion of other stock from the same corporation that was qualified small business stock, the stock acquired will also be qualified small business stock. (I.R.C. section 1202(f)). Also, if qualified small business stock was received as a gift, as an inheritance, or as a distribution from a partnership, the transferee is entitled to the benefits of I.R.C. section 1202 in the same manner as the transferor of the stock. (I.R.C. section 1202(h)). In addition, I.R.C. section 1202(h)(4) provides special rules, requirements, and limitations for preserving qualified small business stock for exchanges of qualified small business involving incorporation under I.R.C. section 351 and non-taxable reorganizations under I.R.C. section 368.

The policy behind the exclusion was to provide incentives to invest in new business endeavors. Consequently, the “originally issued” requirement eliminates stock that was acquired from another stockholder or acquired in a secondary market. Regarding the “originally issued” requirement, a question often arises as to whether the ownership interests of an LLC classified as a partnership (or as a disregarded entity) for tax purposes and converted to a corporation can be qualified small business stock. Even though there are no interpretative regulations on this question, the general consensus is that an interest in an LLC that converts to a C corporation by legally changing its status under state law or by filing an entity classification election for tax purposes with the I.R.S., can qualify as qualified small business stock (Dolson, 2025; Melton and Brown, 2025; Benson et al., 2023.). S. Dolson convincingly argues in “To be Clear… LLCs Can Issue Qualified Small Business Stock (QSBS),” that although I.R.C. section 1202 refers to “qualified small business stock” and “domestic corporation,” a membership interest in an LLC that files an entity classification election to be classified as a corporation can be eligible for I.R.C. section 1202 benefits. Further, he notes that there is no reference in I.R.C. section 1202 to a “state-law” corporation (Dolson, 2025). Treas. Reg. section 301.7701-1(a) provides that federal tax law determines whether an organization is an entity separate from its owner and not local law (Dolson, 2025). Treas. Reg. section 301.7701-3(a) provides that an LLC is an eligible entity that can elect to be classified as an association for tax purposes. Treas. Reg. section 301.7701-2(b)(2) provides that the term, “corporation” includes an “association.” Treas. Reg. section 301.7701-3(g)(1) describes that a partnership electively converting to an association or a disregarded entity electively converting to an association, is deemed to exchange its “stock” for assets deemed contributed (Dolson, 2025).

ertain corporate redemptions of its own stock can disqualify stock from its qualified small business status for an affected taxpayer. (I.R.C. section 1202(c)(3)). Such redemption includes redemption from the taxpayer or from a person related to the taxpayer that occurred two years prior to the issuance of the stock or two years after the issuance of the stock. (I.R.C. section 1202(c)(3)(A)). Significant redemption made by the corporation can also disqualify stock from qualified small business status. Significant redemptions are defined as one or more redemption occurring one year prior to the issuance of the stock or one year after the issuance of the stock and the aggregate value of the redemption exceeded 5% of the aggregate value of all its stock at the beginning of the two-year period. (I.R.C. section 1202(c)(3)(B)).

Qualified small business stock must also meet other requirements. The corporation must be a C corporation and meet the active business requirements “during substantially all of the taxpayer's holding period” of the stock. (I.R.C section 1202(c)(2)(A)). The active business requirements are two-fold: (1) at least 80% of the value of the assets of the corporation are used in the active conduct of one or more “qualified trades or businesses; ” and (2) the corporation is an “eligible corporation.” (I.R.C. section 1202(e)(1)).

Special rules apply in calculating the above 80% test. A reasonable amount of working capital, or assets held for investment that are expected to finance research and experimentation within two years, will be considered used in the active conduct of a trade or business subject to a limitation of 50% or less of the assets of the corporation after the corporation has been in existence for at least two years. (I.R.C. section 1202(e)(6)). Furthermore, there is a limitation on the amount of real estate that will qualify as assets used in an active trade or business. Real estate exceeding 10% of the total value of the assets will disqualify the corporation from meeting the active trade or business requirement. (I.R.C. section 1202(e)(7)). Renting, dealing, or owning real property is not considered a qualified trade or business. (I.R.C. section 1202(e)(7)). Rights to computer software that create royalties are treated as assets used in the active conduct of a trade or business. (I.R.C. 1202(e)(8)).

With respect to the 80% active trade or business asset test, there is a special rule for corporations that own stock in other corporations. Stock and debt owned in a subsidiary (ownership in the subsidiary of more than 50% of the combined voting power of all classes of stock or more than 50% in value of all outstanding stock) is disregarded and the parent is “deemed to own its ratable share of the subsidiary's assets and to conduct its ratable share of the subsidiary's activities.” (I.R.C. sections 1202(e)(5)(A) and (C)). Furthermore, if more than 10% of the value of the corporation's assets consists of stock in other corporations that are not subsidiaries, it will fail the 80% test. (I.R.C. section 1202(e)(5)(B)).

A qualified trade or business is any trade or business except:

1. A service trade or business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage, or any trade or business where the principal asset is the reputation or skill of one or more employees; (I.R.C. section 1202(e)(3)(A)).

2. Banking, insurance, financing, leasing, investing, or similar business; (I.R.C. section 1202(e)(3)(B)).

3. Farming, including trees; (I.R.C. section 1202(e)(3)(C)).

4. Mining and oil and gas; (I.R.C. section 1202(e)(3)(D)).

5. Hotels, motels, restaurants, or similar businesses; (I.R.C. section 1202(e)(3)(E)).

An “eligible corporation” is a domestic corporation except a DISC (Domestic International Sales Corporation) or former DISC, a regulated investment company (mutual fund), a REIT (Real Estate Investment Trust) or REMIC (Real Estate Mortgage Investment Conduit), and a cooperative. (I.R.C. sections 1202(e)(4)(A), (B) and (C)).

As the term, “qualified small business” signals, the corporation must be “small” as defined in the statute. For stock issued on or before July 4, 2025, the aggregate cash and adjusted basis of the corporation's assets cannot exceed $50 million at all times on or after August 10, 1993, and before and immediately after the stock issuance. (old I.R.C. section 1202(d)(1)(A), I.R.C. sections 1202(d)(1)(B) and 1202(d)(2)(A)). Under OBBBA, for stock issued after July 4, 2025, the $50 million limit was increased to $75 million. (new I.R.C. section 1202(d)(1)(A) and (B)). To prevent “stuffing” the corporation with low tax basis assets, for purposes of the $50 million/$75 million threshold, any property contributed to the corporation will be equal to the fair market value of such property. (I.R.C. section 1202(d)(2)(B)).

Corporations that are members of the same parent-subsidiary controlled group (as defined in I.R.C. section 1563(a)(1) except that more than 50% will be substituted for at least 80%) will be treated as one corporation. (I.R.C. section 1202(d)(3).). The Secretary of the Treasury can require the corporation to issue reports to carry out the purposes of the asset limitation test. (I.R.C. section 1202(d)(1)(C).) In Natkunanathan v. Commissioner (T.C. Memo 2010-15, aff'd, 479 Fed. App'x 775 (9th Cir. 2012)), the Tax Court found that the taxpayer did not produce sufficient evidence that the corporation at issue met the asset limitation test.

To carry out the intent of the statute, i.e. to encourage new business investment, I.R.C. section 1202(i) provides special rules for stock received in exchange for property and for contributions of property to capital. Solely for purposes of determining the requirements and amount of exclusion under I.R.C. section 1202, if a taxpayer transfers property to a corporation in exchange for stock of the corporation, the stock is considered as acquired by the taxpayer on the date of the exchange, i.e., there is no carryover holding period attributable to the property that was transferred. (I.R.C. section 1202(i) (1)(A)). The basis of the stock acquired in the exchange will not be less than the fair market value of the property transferred. (I.R.C. section 1202(i)(1)(B)). With respect to contributions to capital of property that increase the basis of qualified small business stock held by the taxpayer, the amount of the basis adjustment will be no less than the fair market value of the property contributed. (I.R.C. section 1202(i) (2)). This fair market value rule is in contradiction to the general carryover basis rule in other Internal Revenue Code sections, such as I.R.C. section 358 (basis of stock involving transfers to controlled corporations and in non-taxable reorganizations.) The purpose of this rule is to limit the amount of eligible gain to the appreciation of the stock after the contribution of the property. Consequently, pre-contribution gain is not eligible for the exclusion.

Founders of new enterprises desiring outside capital must wrestle with the choice of business entity. Many factors must be considered. The choice is typically between an LLC and a corporation. S corporations are usually excluded because S corporations limit the type of person who can be a shareholder. Institutional investors are generally not eligible S corporation shareholders. C corporations are disadvantaged due to the exposure to double taxation. Nevertheless, C corporations are generally favored when considering utilizing the benefits of I.R.C. section 1202. LLCs offer single-level taxation and pass-through treatment to owners for early-stage operating losses. As discussed above, members of an LLC can avail themselves of the benefits of I.R.C. section 1202. LLCs by converting the LLC to a C corporation. It should be noted that an LLC that converts to a C corporation will have dual governing laws: (1) state law for non-tax operations of the business; and (2) federal and state tax laws for taxing the entity and its owners.

If the tax benefits of I.R.C. section 1202 are a principal incentive, it begs the question, why not just organize as a C corporation rather than organize an LLC with a subsequent conversion to a C corporation? In an insightful article, “Considering Converting an LLC into a Corporation? Here Are the QSBS Issues You Should Be Thinking About,” G. Benson answers the above question and provides helpful planning ideas and perspectives. (Benson et al., 2023). Benson offers a potential strategy to initially organize as an LLC, classified as a partnership, and later convert the LLC to a C corporation. The advantages are (1) pass-through early stage losses to the members (assuming the members have personal tax basis to deduct the losses); and (2) maximize the 10 times basis limitation in the exclusion formula. As discussed above, the per issue exclusion is limited to the greater of $15 million (under OBBBA) or 10 times the adjusted basis of the stock. Under I.R.C. section 1202(i), the basis in the stock is equal to the fair market value of the property exchanged, not the carryover basis. If the conversion from a pass-through LLC to a C corporation is delayed when the assets of the business have appreciated, the conversion to a C corporation may enhance the 10 times prong of the exclusion formula. (Benson et al., 2023) Benson cautions that delaying the conversion to a C corporation may run afoul of the gross asset limitation ($75 million under OBBBA, $50 million under pre-OBBBA). A disadvantage to forming an LLC and later converting to a C corporation is that any pre-conversion gain is not eligible for the exclusion. (Benson et al., 2023). In addition, converting an LLC classified as a partnership to a C corporation may result in taxable gain recognition to the members if the entity has significant debt at the time of the conversion (I.R.C. sections 752 and 731). (Benson et al., 2023).

I.R.C. section 1202 offers generous tax benefits for entrepreneurs contemplating selling their business. This statute is complex and contains many hurdles to achieving its benefits. Unfortunately, there is little-to-no official guidance except for the statutory language. Tax planning without specific guidance can create risks as well as opportunities. Hopefully, regulations will be forthcoming.

Nevertheless, with the OBBBA expansion of tax benefits offered by I.R.C section 1202, importantly, the $15 million per issuer exclusion and the $75 million gross asset limit, entrepreneurs must carefully consider whether a C corporation is preferred. The OBBBA modifications to I.R.C. section 1202 may have changed the negative sentiment toward C corporations. For many businesses that anticipate a very profitable exit strategy, organizing as a C corporation, or organizing as an LLC with a view to converting to a C corporation has now become a more accepted viable tax planning strategy.