Infographic: The Process of Converting Your Business for Qualified Small Business Stock

In a previous article, we examined the potential capital gains tax benefits of positioning your business to be sold through Qualified Small Business Stock (QSBS). If you currently have a pass-through business and are looking to sell using this strategy, one of the requirements you’ll need to meet is converting to an C-corporation. Here’s an illustration of how the process could work.

1. The Smith family owns Company S, a pass-through operating business with gross assets of $20MM and a basis of $2MM.

2. Smith family decides they would like to sell the business within the next 5-7 years, allowing the second generation to benefit from the family wealth but not be tied to the family business.

3. Considering the Tax Cut and Jobs Act of 2017, the lack of a 199A deduction for their specified business, and a 5+ year timeline for a sale, the family’s advisor team makes a case for pursuing a QSBS exclusion on the sale of Company S.

4. The Smiths, through their advisors, open up Company C, an operating C-corporation.

5. Property of the pass-through is contributed in exchange for controlling (>80%) ownership interest in the C-corporation. Under rule 351(a) the transfer is not subject to income/capital gain/loss recognition.

6. The family maintains the ownership of Company C through the holding Company S.

7. After 5 years, the Smith’s put Company C up for sale, with a basis of $3MM and gross assets of $20MM.

8. Company C is sold that year for $30MM, and no federal capital gains tax is paid because the sale proceeds, after closing costs, are less than 10x the basis in the company.

9. The cash is then distributed to the owners of the pass-through, with complete exclusion of all gains.

As always, it’s always crucial to work with experienced advisors who understand not only the nuances of these complicated tax regulations, but how converting your business and planning a succession with QSBS fit your broader life and financial goals.