Only C-Corporations can qualify to issue Qualified Small Business Stock (QSBS) per Section 1202.
C-Corporations or “C-Corps” are legal entities in which the owners or shareholders are taxed separately from the entity. C-Corps are taxed on their income before paying out earnings in the form of dividends to shareholders, and those distributions are then taxed at the individual shareholder level as well.
Not every type of C-Corp can qualify for issuing QSBS. Companies incorporated in the U.S. as C-Corps are eligible for QSBS unless the corporation was formed as:
A C-Corp can conduct business internationally, but it has to be incorporated in the US to qualify for QSBS.
In order to qualify as a Qualified Small Business, the corporation has to be a C-Corp on the security issuance date.
If the business was formed as a different legal structure (e.g. LLC, S Corporation, Partnership), the company can terminate its legal structure to re-incorporate as a C-Corp before the issuance/sale of the stock.
Converting a legal entity raises various complications. For example, if an entity is converting from an S-Corp to a C-Corp, it is not as simple as transferring stock for stock in the new entity as stock-for-stock transfers do not qualify for QSBS. It may be possible for the owners of the S-Corp to transfer the assets of the S-Corp to a C-Corp in exchange for QSBS under a tax-free exchange pursuant to IRC Section 351(a).
Section 1202 states that “‘qualified small business’ means any domestic corporation which is a C corporation” and does not explicitly state treatment for an LLC taxed as a C-Corporation.
However, in Ltr. Rul. 201636003 a tax-free reorganization involving an LLC taxed as a C Corporation converted to a C Corporation in order to qualify as QSBS with a holding period starting the date that the membership interest in the LLC was acquired. This means the IRS viewed the membership interest in the LLC taxed as a C Corporation as QSBS for Section 1202 purposes in this particular case.