C and S Corporations for Estate Planners: QSBS Through Pass-Throughs

Exploring original issue, and considerations for tiered ownership structures

Table of Contents

1. Background

2. Example 1: Top-Down Approach

3. Example 2: Drop-Down Approach

4. Conclusion

Background

The last article in this series explored some of the basis rules around contributions of property for stock under IRC Section 351, and contrasted those basis rules with those that apply for purposes of the gain exclusion and qualifications for qualified small business stock (QSBS) under IRC Section 1202. Given the recent increases to the QSBS gain exclusion under OBBBA, this has increasingly become a hot topic.

Importantly, the QSBS rules now have two sets of exclusions – those that apply pre-OBBBA, and those that apply post-OBBBA.[1] The post-OBBBA rules require QSBS to be originally issued after OBBBA was enacted, to start the 3-5 year holding period for the gain exclusion. Recall that this means stock in a C corporation (or an entity taxed as a C corporation) is directly issued by the corporation (not purchased from another shareholder) in exchange for cash, property (subject to the rules we have been discussing under IRC Section 351), or services (subject to different rules we will table for now).

This presents an issue for a business that was not taxed as a C corporation at the time of original issue, especially if the path to reach C corporation taxation means recognition of gain. It also presents unique issues for complex entity ownership structures, many of which have not been addressed in Treasury Regulations, rulings, or other determinations. In other words, it is rare that QSBS is directly owned by individuals, or that the active business assets of a qualified small business are directly held by the issuing C corporation.

Instead of rote regurgitation of the QSBS rules here, we will use examples to illustrate some of what is possible. By no means are these examples inclusive of all possibilities, but for the sake of illustration of various Code principles two fairly simple structures are used.

Example 1: Top-Down Approach

Let’s take an entity that is organized as either a tax partnership, or an S corporation. Could we create a new C corporation, and have each shareholder contribute their interests in the existing entity to the newly-formed C corporation in exchange for original issue stock?

The outcome might look something like this: