Converting an LLC to a C corp: A QSBS tax exemption guide

Choosing the right business structure is one of the first and most important decisions you'll make when founding a company. One major reason is that the structure of your business impacts your ability to qualify for the qualified small business stock, or QSBS, exclusion—a tax break that could dramatically cut the amount of capital gains tax you'll owe when you sell eligible shares.

To explore these considerations in more depth, Ann Lucchesi, Senior Director at First Citizens Wealth, and Danielle Greene, Director of the Fiduciary Governance Group at First Citizens, sat down for a conversation exploring the pros and cons of structuring a business as a limited liability corporation, or LLC, or an S or C corporation in relation to the QSBS exclusion. In the exchange that follows, they examine the nuances of different business structures on QSBS eligibility, as well as whether converting from one structure to another is worth the effort.

Business structure and QSBS eligibility

Lucchesi: Starting a new company requires careful planning because there are multiple types of structures with differing tax consequences. To qualify for the QSBS exclusion, you'll need to have acquired your shares from a C corp. However, there's some flexibility in starting as an LLC and later converting to a C corp. Danielle, would you walk us through the taxation of an LLC versus a C corp?

Greene: An LLC is a hybrid entity that offers certain benefits of a corporation—such as limited liability—along with the option to be taxed as a partnership and obtain benefits like flow-through income and losses.

Meanwhile, a C corp is its own tax-paying entity where income and loss are paid at the corporate level. If a C corp pays dividends to its shareholders, the shareholders must pay income tax on those dividends at their individual level. So as you're just starting a business, it might be advantageous to avoid double taxation and opt for a flow-through entity.

Lucchesi: One of the things I've seen happen to some founders is they'll start their business as a C corp, but then their accountant tells them to take an S-corp election because many businesses experience tax losses in their early years. Unfortunately, this would disqualify them for the QSBS exemption, so it would be better to operate as a pass-through LLC during the start-up years and convert to a corporation when the business can benefit from the QSBS rules. Could you speak to conversion and the potential downsides of this approach?

Greene: An S corp is a business entity that makes a special election with the IRS to be treated as a flow-through or pass-through entity, similar to an LLC. So you get positive tax treatment, but there's a downside. S corps aren't eligible for QSBS tax benefits, while an LLC converted to a C corp—prior to exceeding the gross-assets test under QSBS—would qualify.

Timing considerations for a conversion

Lucchesi: Entrepreneurs starting a business that meets the definition of a qualified small business have traditionally been advised to organize their company as a C corp in order to qualify for QSBS status and start the 5-year holding period.

However, there's been some thinking recently that if you start the company as an LLC and then convert to a C corp prior to breaching the gross-assets test for QSBS, you might be able to maximize your QSBS exclusion in a liquidity event.

What happens during a large seed round when a business that started as an LLC converts to a C corp? How does it work for the purposes of valuation of your shares—and what's the impact on QSBS eligibility?

Greene: Basis is important because QSBS exempts the greater of $10 million or 10 times the adjusted basis. With the passing of the One Big Beautiful Bill Act, if you acquire qualified shares after July 4, 2025, the cap has been increased from $10 million to $15 million and will be indexed for inflation beginning in 2027.

In these conversions, the basis of the property is equal to the fair market value when it's converted to a C corp, so if the basis exceeds $1 million—or $1.5 million on shares converted after July 4, 2025—the founder could benefit from an increased QSBS benefit. The conversion also resets the clock for the 5-year holding period. So while the basis step-up can be favorable, restarting the 5-year holding period could impact eligibility at the time of a sale of shares.

Lucchesi: Let's say I'm a founder and started the company as an LLC. I own 20% of the company, and it's valued at about $25 million at the time of conversion from an LLC to a C corp. My basis would be $5 million—20% of $25 million. Does this mean I'd be eligible for the greater of the two exclusions, which in this case would be 10 times $5 million, or a $50 million exclusion?

Greene: That's exactly right. Your gain on the sale of those assets would be tax-free up to $50 million.

Meeting the gross-assets test

Lucchesi: One of the things owners need to be careful of is the impact of conversion timing and the gross-assets test. Could you talk about the gross-assets test?

Greene: The gross assets at conversion can never have exceeded $50 million or $75 million for shares acquired after July 4, 2025. So in big seed rounds, if this infusion will increase the assets above those thresholds, then the stock won't be eligible for the QSBS exemption.

Lucchesi: So if owners time this correctly, they could end up having a large exclusion, but if they time it wrong—and at the time of conversion it's $51 million in gross assets—none of their shares would be QSBS-eligible.

Greene: That's correct.

Lucchesi: The key takeaway for owners and investors is to time a conversion carefully. It's a good idea to engage with advisors to make sure they won't exceed the gross-assets threshold when they convert an LLC to a C corp.

The bottom line

It's essential for founders to understand the pros and cons of various business structures, including C corps, LLCs and S corps. Only C corps qualify those who hold stock for the QSBS exclusion, which can offer major tax savings. However, a conversion from an LLC to a C corp must be timed correctly to be eligible for this exemption, and it's critical to have proper advice to make sure the conversion is compliant for QSBS eligibility.

In addition to QSBS, there are several other considerations to account for in your choice of entity structure, like tax implications, ownership goals and liability protection. As always, proper planning with financial and tax advisors can help founders choose the right business structure for their unique situation.

Key takeaways

• When determining your choice of entity structure, consider the impact of QSBS, tax implications, ownership goals and liability protection.
• Only C corporations qualify for the QSBS exclusion, which can offer major tax savings like unlocking potential capital gains tax exclusion benefits up to $15 million—or 10 times the adjusted basis.
• A conversion from an LLC to a C corp must be timed correctly to be eligible for QSBS exemption.