Valuable QSBS Opportunity for Investors and LLC’s to End on December 31, 2011

In our blog post from December 2010, we discussed the potential for investors to acquire certain qualified small business stock (“QSBS”) and be eligible to exclude 100% of the gain realized on a subsequent sale of that QSBS, if held for at least five years. That 100% gain exclusion for QSBS was enacted by Congress as a part of the Small Business Jobs Act of 2010 (“SBJA 2010”) and then extended as a part of the Tax Extension Act of Dec. 17, 2010. Potential investors have a limited window to take advantage because this special exclusion only applies to QSBS acquired before January 1, 2012.

The 100% gain exclusion described above is, however, limited to the greater of (i) $10 million or (ii) 10 times such taxpayer’s basis in the QSBS. $10 million is a pretty high cap, but certain LLC’s may be able to do even better.

In the event the QSBS stock is acquired in an exchange (i.e. not for cash), the Section 1202 rules determine a taxpayer’s basis in its QSBS stock to be equal to the fair market value of property transferred. So, while a start-up company may have been created as an LLC, with very little cash being contributed by its investors, if that LLC start-up has increased in value, the investors may consider converting the LLC to a corporation. Assuming that the stock the investors receive in the LLC conversion will be QSBS, the investors will be eligible for the 100% gain exclusion on a later disposition of that QSBS. Assuming that the LLC, at the time of its conversion, had a value at least $1 million, the cap on the gain exclusion will be increased (since the cap is equal to 10 times that value). So, if the LLC had a $5 million value at the time of its conversion, the gain that could be excluded on its sale is capped at $50 million; much higher than $10 million cap that might otherwise apply. In summary, by organizing as an LLC initially and creating value in that LLC prior to corporate conversion, an investor can increase his potential for QSBS gain exclusion.

While the gain exclusion described above benefits QSBS investors in a stock sale exit transaction, the LLC form may still be better in the event of an asset sale exit transaction. Many other differences exist between LLC’s and corporations, so all factors should be thoroughly considered before an LLC is converted to a corporation to take advantage of the QSBS benefits described above.

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Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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