The New QSBS May Be TOO Good
- May 20
- 2 min read
In a prior newsletter, we covered a popular strategy to allow founders to directly benefit from QSBS rules (“The Strategy”). The new QSBS rules might make The Strategy too good.
The Strategy
Typically, Qualified Business Stock (QSBS) is a benefit for investors in small businesses. Investors that purchase QSBS can exclude taxes on gains upon sale of the stock. Prior to 2025, investors could exclude the greater of (a) $10 million in gain and (b) 10x their basis. Thanks to the Big Beautiful Bill (OBBBA), they can now exclude the greater of $15 million and 10x their basis.
That QSBS benefit eluded founders, who typically don’t pay for their stock, but instead are awarded the stock at an extremely low value. But The Strategy allows founders to take advantage of QSBS by initially forming an LLC. If the founders form an LLC, and later convert that LLC to a C Corp, they can treat the value of the LLC at conversion as their basis in the C Corp. As an example, if they converted when the LLC was worth $30 million, they could exclude $300 million in C Corp gains. Prior to 2025, to take advantage of this strategy, founders would need to convert when the LLC was worth less than $50 million.
The New Threshold
Under OBBBA, that $50 million threshold was increased to $75 million. But this greater reward comes with a greater risk. A $75 million conversion is ideal if the business is later sold for $825 million ($75 million plus 10x that basis). But what if the business sells for “only” $100 million? In that case, the LLC owners would have been better off converting at a lower value. Why? Because the LLC gain is not exempt from tax. That’s right, the founders must recognize a gain on their LLC interest upon conversion (though they needn’t pay the tax on that gain until the C Corp is sold).
If the LLC conversion takes place at a higher value, that means more tax on the LLC gain. If paying tax on $60 million (for example) lets you exclude $600 million in gain, that’s a good bargain. But if you are only going to recognize an additional $40 million in gain, you would have been better off converting at a lower value.
The QSBS rewards are so great now, that they may be too great. They might entice founders to convert at a value that’s so high, they would never be able to fully recognize the tax benefits and would instead end up paying more tax than they would have if they converted at a lower value. Waiting to convert also delays the start of the clock on the QSBS holding period (the exclusion only fully applies when you’ve held the stock for five years).
You’ve heard that a bird in the hand is worth two in the bush. But is it worth ten? It might be, especially if you know your target exit value won’t let you recognize the ten. It’s important for founders to consider just how large of an exit they are planning when timing their LLC conversion. And, of course, keep in touch with your valuation provider to have an understanding of your company’s approximate value.
Eric Sundheim, ASA
Principal
Mercovus Valuations
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