Rethinking a C Corporation as a Choice of Entity

Over the past several years, the choice for the formation of a new entity has frequently been an S Corporation or Limited Liability Corporation, usually to avoid the double taxation resulting from the disposition of the business.  This Blog summarizes the special tax advantages available to C Corporation shareholders who sell stock in qualified small business corporations (QSBCs). A QSBC is a C corporation that meets certain criteria. The potential tax benefits can represent a significant inducement to form a C Corporation instead of an S Corporation or Limited Liability Corporation. Therefore, it is important to understand these benefits and plan for them to be available when possible.

Stock will either be QSBC stock in the hands of shareholders or not. QSBCs are treated as regular C corporations for all other legal and federal tax purposes. (Beyond the federal income tax gain exclusion and gain rollover breaks, the standard advantages and disadvantages of C corporation status apply equally to QSBCs.) To be eligible for the QSBC gain exclusion and gain rollover breaks, stock must meet the requirements set forth in IRC Sec. 1202, including the following:

•The stock must have been issued after 8/10/93 by a C Corporation with aggregate assets of $50 million or less, and the taxpayer generally must have acquired the stock: (1) upon original issuance (either directly or through an underwriter) or (2) through gift or inheritance.

•The stock must be acquired in exchange for money, other property (not including stock), or services (not including services performed as an underwriter). However, some tax-free transfers and exchanges can also qualify, such as when stock is acquired through gift or inheritance.

•The corporation must be a QSBC at the date of the stock issuance and during substantially all the period the taxpayer holds the stock.

The following do not qualify as a QSBC [IRC Sec. 1202(e)(3)]:

1. any trade or business involving the performance of services in the fields of  health, law, engineering, architecture, accounting, etc.;

2. banking, insurance, financing, leasing, investing, or similar business;

3. farming (including the business of raising or harvesting trees);

4. the production or extraction of products subject to percentage depletion; and

5. a hotel, motel, restaurant, or similar business.

In addition, a corporation will not be treated as a QSBC for any period during which more than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business. For purposes of the preceding sentence, the ownership of, dealing in, or renting of real property will not be treated as the active conduct of a qualified trade or business.

An eligible corporation is any domestic C corporation other than (1) a DISC or former DISC; (2) a corporation (or its subsidiary) that has a Section 936 (i.e., possessions credit) election in effect; (3) a regulated investment company (RIC), real estate investment trust (REIT), or REMIC; or (4) a cooperative [IRC Sec. 1202(e)(4)].

Special QSBC Tax Benefits

The unique income tax benefits available to sellers of QSBC stock are:

•        The ability to exclude a portion of the resulting gains from taxation if the stock was acquired:
~ between September 28, 2010 and December 31, 2011 – 100% excluded
~ between February 18, 2009 and September 27, 2010 – 75% excluded
~ between August 11, 1993 and February 17, 2009 – 50% excluded
~ after December 31, 2011 – 50% excluded

•        The ability to roll over (defer) gains by reinvesting in newly issued shares of another QSBC. The gain exclusion and gain rollover is available only for original issue shares received after August 10, 1993 and held for over five years. Shareholders that are themselves C corporations are ineligible. The taxable part of the gain from the sale of QSBC stock is taxed at 28% up to the amount of excluded gain.

Calculating the Gain Exclusion Limits

Note that IRC Sec.[1]1202(b)(1) limits the amount of gain eligible for the 50% (75% for stock acquired after February 17, 2009 and before September 28, 2010, and 100% for stock acquired after September 27, 2010, and before January 1, 2012) exclusion in a tax year with respect to a particular QSBC to the greater of

  • 10 times the taxpayer’s aggregate adjusted basis in the qualified small business stock that is sold, or
  • $10 million ($5 million for married filing separate status) reduced by the amount of eligible gain taken into account in prior tax years for dispositions of stock issued by the same corporation. This limitation is a lifetime per corporation limitation – it applies to the cumulative gains from dispositions of qualified small business stock.

Below are examples of the operation of each limitation:

Example 1 – $10 million eligible gain limitation

Tom and Glenda Henderson, who file a joint return, sold qualified small business stock acquired January 3, 2004 with a basis of $600,000 for a gain of $30 million in 2011. This was the first time they sold stock in that corporation. The maximum gain eligible for the 50% exclusion is the greater of $6 million (10 times the basis of the stock sold) or $10 million reduced by eligible gain taken into account in prior tax years (i.e., $10 million minus zero). Thus, the Hendersons can exclude $5 million of gain from gross income (50% of $10 million).

Example 2 – 10 times the basis limitation

Steve and Nancy Larsen, who file a joint return, sold qualified small business stock acquired June 25, 2001 with a basis of $3 million for a gain of $8 million in 2011. They had taken eligible gains of $7 million into account in earlier tax years related to this same corporation. The maximum gain eligible for exclusion is the greater of $30 million (10 times the basis) or $3 million ($10 million less the $7 million used up”). Thus, the Larsens entire $8 million gain is eligible for the 50% exclusion (under the 10 times the basis limitation), and they can exclude $4 million of gain.

In summary, a C Corporation certainly deserves entity consideration for businesses that can meet the qualifications for a QSBC. The QSBC benefits need to be evaluated alongside the benefits of an S Corp and LLC and the long-term plans of the owners.


About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: