Here in Michigan, the LLC is a popular choice for new businesses. I’ve seen companies ranging from new STEM startups, to the new venture created by experienced industry veterans, use this flexible, cost efficient entity choice and never look back. In general, tax-wise, if the LLC is taxed as a partnership, then income and loss passes through the entity directly to its owners and the dreaded C corporation “double taxation” (tax to the corporation on its income, then tax to its shareholders on distributions) is avoided.
The LLC/partnership tax treatment is frequently preferred by founders for tax efficiency during their ownership of the LLC. However, when interests in a LLC are eventually sold, the selling members may experience taxable gain and tax liability as if they had sold any other asset that grew in value.
Unless those founders held their new venture in Section 1202 Qualified Small Business stock, which offers exclusions of up to 100% of capital gains upon eventual stock sale of IF a number of conditions are met.
First, just as there is no free lunch, there is no easy gain exclusion. For Internal Revenue Code Section 1202 to apply, the company and founders must have met all of the tests set forth in the Internal Revenue Code (including (i) at least 80% of assets used in an active business (service businesses, hotels and some other types of business excluded), (ii) revenues not exceeding $50 million at the time stock was acquired, and (iii) taxpayer is not a corporation, and held stock for at least 5 years after acquisition) and Congress must continue to extend the capital gain exclusion (currently at 100% for stock acquired through 12/31/2014) – which may occur at the end of 2015 (not convenient for tax planning).
In a world of LLCs (often rightly chosen) there are some serial entrepreneurs who favor Section 1202. Sure, it’s a balancing act between possible double taxation and gain exclusion on sale, and as we must wait every year for year-end tax extenders and patches from Congress, the availability of Section 1202 for 2015 and later years is uncertain. However, for some founders and some circumstances, this may be an appropriate option.
Interested in Section 1202, but you’d like to own it through a LP or LLC? Interested in buying Section 1202 stock, but the corporation has redeemed a significant chunk of its stock recently when other shareholders departed? Consult a business tax professional ASAP, as Section 1202 offers great benefit along with great statutory detail and disqualifications that must be understood before money changes hands. In some circumstances, though, it might be worth a look.