Client Alert: Taxable Entity Choice and the Lure of C Corporations
Date: September 23, 2025
By:
Kurt R. Magette
When two or more owners truly have a choice of tax classification for an entity, that choice is the most important tax decision they may ever make. Before the 2017 Tax Act, the decision was easy. In almost every circumstance, an entity should have been an LLC that elected to be taxable as a partnership (an “LLC”). After the 2017 Tax Act, the choice became much harder. This difficulty was largely due to the inversion of tax rates and the Section 1202 Gain Exclusion. These changes caused many owners to select C corporations or to convert their entities into C corporations.
Tax advisors argue that the 2017 Tax Act inverted the tax rates, causing C corporations to have lower tax rates than individual owners in an LLC. That argument needs to be expanded and examined, however. A C corporation has lower ordinary income tax rates for federal purposes. A C corporation does not get a rate reduction for long-term capital gain, nor, in most states, does a C corporation have lower state income taxes than individuals in an LLC. More importantly, the shareholders in a C corporation face double taxation for appreciation in C corporation assets.
For a variety of reasons, an S corporation is almost never a desirable choice of tax entity unless it is the result of a conversion of a C corporation.
With the lure of lower federal rates on operating income and the potential of Section 1202 Gain Exclusions, owners currently choosing an entity might seriously consider a C corporation. However, they need to look before they leap. C corporations are relatively easy to organize and capitalize (at least at the beginning or at any time with cash contributions). However, cashing out through an asset sale or liquidation is very painful. If the owners can engineer a stock sale, the Section 1202 Gain Exclusion may assist.
The conditions and limitations on qualifying for the Section 1202 Gain Exclusion are numerous and complex. However, if an individual holds qualifying stock in a C corporation acquired after September 27, 2010, for more than five years, the excluded “gain” for federal and Virginia income tax purposes is 100%. The 2025 Tax Act liberalized many of the requirements. Basically:
- These rules only apply to individual shareholders who have held their stock for over five years. However, as discussed below, qualifying stock acquired after July 4, 2025, has special periods and exclusion amounts;
- The stock must have been issued by the C corporation to the individual (and not purchased from another shareholder, for example), although special rules apply for gifts and bequests of stock and stock owned by “pass-thru entities”;
- The C corporation must be involved in an active business, which generally excludes most businesses that are service-provider businesses or that involve farming. Research and development companies have special dispensation;
- The amount and type of assets in the C corporation are limited;
- The exclusion only applies to a sale of stock; and
- The aggregate amount a taxpayer excludes in all stock sales under such Section is limited.
Many owners of current or future businesses are certain their business will be successful. That is one of the keys to success. Some of these owners believe the business will be sold in a stock sale before or after merging with an acquiring corporation. These expectations may compel the owner to choose a C corporation. This compulsion may be especially strong if the C corporation can accumulate its income without creating higher tax rates and without paying dividends (“Accumulating C Corp”) and, thereby, avoid double taxation on operating income.
In capital-intensive businesses, however, appreciation in assets propels this success, and accumulating income compounds appreciation. The tax advantages of an LLC when the business has appreciating assets are numerous, substantial, and beyond the scope of this Alert.
Thus, even if the business can be an Accumulating C Corp, the owners take a substantial risk using a C corporation rather than an LLC. A C corporation cannot benefit from many tax advantages of an LLC if, before a stock sale qualifying for the Section 1202 Gain Exclusion, for example, an owner dies, only one owner’s equity is redeemed or is sold, the business splits, or the entity wants to borrow and distribute the loan proceeds tax free. The forfeited tax benefit may be huge.
The 2025 Tax Act made this calculus more difficult. For qualifying stock acquired after July 4, 2025, the excluded “gain” is 50% for such stock held three years or more; 75% for such stock held four years or more; and 100% for such stock held five years or more.
If a business has already become successful and is issuing equity to individual investors, the new investors may dictate that the business be, or become, a C corporation to begin their Section 1202 Gain Exclusion holding period. Our focus, however, is on two or more owners that are organizing an entity and selecting its tax classification.
For the business being organized, the owners may take a “wait and see” approach. The Section 1202 Gain Exclusion will be a mirage to most businesses. An event that benefits from the many LLC tax advantages may occur before the minimum holding period, even if it is three years. A tax-sensitive buyer may require a significant discount for tax and business reasons to acquire (or be deemed to acquire) stock rather than assets.
The “wait and see” approach is not without risk. First, if the owners wait to convert their LLC to a C corporation, they may never even eclipse the three-year holding period, much less the five-year period before a stock sale is advisable. Second, generally, the “gain” excluded is limited to the post-stock issuance appreciation. For example, A and B are tax partners in an LLC. At the time the LLC converts to a C corporation (after July 4, 2025), the aggregate tax basis of its assets is $4MM, but their value is $10MM. Generally, the basis of the issued stock would be $4MM, but the effective basis for the Section 1202 Gain Exclusion is $10MM. Assume that the stock is sold five years after conversion for $22MM and that the many other requirements of the Section 1202 Gain Exclusion are met. Also, assume A and B have never used the exclusion in other instances. The excluded gain Is $12MM (($22MM - $10MM) X 100%) and not $18MM (($22MM - $4MM) X 100%). The $6MM in pre-issuance/pre-conversion appreciation is fully taxed.
Before the 2017 Tax Act, an LLC was the choice of entity for nascent businesses and for those converting from a sole proprietorship to a multi-owner business. That choice is still optimum for substantially all such businesses. However, the owners and their advisors must have as much current information as possible and have clairvoyance. Businesses that are already successful with owners certain that the Section 1202 Gain Exclusion will be relevant and significantly beneficial should consider the business electing or becoming a C corporation.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.