LLC taxed as a partnership is a typical legal and tax structure for small restaurant groups because it provides limited liability, no double taxation, flexible economic arrangements, and pass-through tax losses to partners. In most cases, closely held businesses are better off structured as pass-through entities—partnerships or S-corporations.
However, fast-growth restaurant groups may reach a point when they need to convert to a C-corporation to raise money from venture capitalists or institutional investors. These investors intend to sell at a higher multiple eventually.
As discussed in The Best Tax Classification for Your Restaurant, C-corporations come with two primary tax disadvantages:
- If the C-corporation generates profit, it will be subject to double taxation if dividends are issued to shareholders.
- If the C-corporation generates a loss, you can’t use those losses on your partner’s tax returns to offset other income. The losses stay in the corporation and get carried forward.
A C Corporation is usually the tax entity of choice for restaurants that follow a “start-up” model, meaning they raise money from venture capitalists or other investors to add multiple locations to exit at a high valuation quickly. The C-corporation is preferred in this model because the primary disadvantage (double taxation) is usually irrelevant because either (1) profits are being reinvested, thus generating a loss, and the restaurant group is not experiencing any gains until a successful exit, or (2) the company is profitable even after reinvesting profits, but no dividends are issued, and owner’s pay is immaterial compared to the company’s valuation.
However, the C-corporation also has a huge advantage for growth businesses: the qualified small business stock (QSBS) gain exclusion under section 1202 of the Internal Revenue Code (IRC). And the mechanics of this advantage impact when you are an LLC Partnership and then convert to a C-corporation. Converting from an LLC to a C-corporation is generally tax-free if structured appropriately under Section 351 of the IRC. Restaurant groups will frequently operate under an LLC during the early years so that losses flow through to partners; profits are not double-taxed and convert to a C-corporation if or when necessary. Although a viable strategy, this approach can significantly impact the QSBS gain exclusion. Other factors can affect the timing of a C-corporation conversion that will not be discussed in this article. For example, you may have profit interest partners that only get equity if the enterprise value increases, and if the enterprise value hasn’t increased based on the required distribution threshold, their ownership in the new C-corporation will be affected. In this article, we will explain the QSBS and how it impacts the timing of your conversion to a C-corporation.
How the Section 1202 QSBS Exclusion Works when Converting to a C-Corporation
Section 1202 allows shareholders of a C-corporation to exclude up to $10m (or 10x tax basis at the time of C-corporation formation, whichever is higher) in capital gains when they sell their shares if they own the stock for at least five years.
For example, assume your restaurant group has five shareholders and was structured as a C-corporation when the first location opened. You could grow your group to $50m, sell your shares after five years, and exclude up to $10m of that gain per shareholder. The Section 1202 exclusion is the difference between your tax basis and the proceeds from a sale. Section 1202 provides that your tax basis in the C-corporation is your share of the fair market value of the assets at the time of formation or conversion of the C-corporation. Any gain accumulated before the C-corporation formation is taxed like any other capital gain. For example, assume your share of the business is worth $3m when you convert to a C-corporation and your share is later sold for $10m; only $7m gain could qualify for sec 1202 gain exclusion, the remaining $3m would be taxed as a capital gain at the time of sale.
Qualifying for the Section 1202 QSBS Exclusion
To qualify for the sec 1202 exclusion, the following must apply:
- The shareholder must own the stock for at least five years before selling
- Shareholders who are C-corporations don’t qualify for the exception
- The fair market value of the corporation’s gross assets must not exceed $50 million at any time before and immediately after the issuance of the applicable stock
- The restaurant group’s assets should be appraised at the time of conversion to a C-corporation. The fair market value of the assets should be shown in a statement on the C-corporation’s initial tax return.
The Section 1202 exclusion is available whether the sale of the C-corporation is structured as an asset sale or stock sale; however, the benefits derived from an asset sale are far less than those of a stock sale. In an asset sale, the gain on sale might be excluded from tax under section 1202, but when the cash is distributed to shareholders, it is taxed at the qualified dividend tax rate of 20%. Therefore, the benefits of a C-corporation drastically decrease when an exit is structured as an asset sale. As a result, buyers may use the tax benefits of a stock sale to negotiate a lower sale price or valuation.
Timing of Formation or Conversion to a C-Corporation
The mechanics of the section 1202 exclusion might make it seem like you want to convert to a C-corporation as soon as possible to keep your tax basis low, the accumulation of gain or increase in enterprise value under the C-corporation and decrease the chance of violating the $50m valuation requirement. However, there’s a caveat that makes the ideal timing of the conversion a little more complicated.
The sec 1202 exclusion allows shareholders to exclude up to $10m gain or 10x your tax basis in the C-corporation at the time of conversion or formation, whichever is higher, as mentioned above. The latter is usually a lot higher later when growing quickly.
For example, assume you convert your five-shareholder restaurant group to a C-corporation when its valuation is $10m, then sell it in 6 years when the value is $50m. The first $10m would be subject to capital gains tax since it was accumulated outside the C-corporation. The remaining $40m would qualify for sec 1202 gain exclusion at the higher of $10m per shareholder or 10x their tax basis in the C-corporation at the time of conversion, which is $10m x 10=$100m. The entire $40m gain would easily be excludable for all partners using the 10x limitation.
With that said, if you expect the value of your restaurant group to go up significantly beyond $10m per shareholder, you want to defer the conversion as late as possible while making sure you retain the company for at least five years before selling and stay under $50m in gross assets before the conversion. If you don’t expect the value of your restaurant group to go beyond $10m per shareholder while it’s in the C-corporation, you are sure that you want to sell, and other advantages and disadvantages have been considered, then you can do the conversion as soon as possible.
Example
We will illustrate the impact of C-corporation formation timing on the section 1202 exclusion by showing various scenarios of a restaurant group that exits at $50m and $300m. The illustration assumes that the time between C-corporation conversion/formation and exit is at least five years and that the company has 10 shareholders.
As you can see from the illustration, if the amount of gain you’re expecting for each shareholder exceeds $10m, you’ll want to postpone the C-corporation conversion as late as possible while still satisfying the $50m gross assets and five-year holding requirements. In scenario 4, the shareholders had to pay capital gains tax on $15m of additional gain because they converted to C-corporation from a partnership when the valuation was $10m instead of $50m.
Conclusion
To sum it up, the time to convert to a C-corporation will depend on where you see the company going. Suppose you see a future exit event at a valuation that results in less than $10m gain per shareholder. In that case, it’s worth making the C-corporation election as soon as possible after considering all factors. However, again, this assumes that you are a growth business intending to exit at a higher valuation; otherwise, closely held companies are typically better off structured as partnerships or S-corporations. It’s also important to remember that things can change. You might be planning to sell in 6 years, but the timeline moves up to 3 years due to an that can’t be turned down. Or maybe you decide not to exit at all. Regardless, if you’re a fast-growing restaurant group, it’s essential to work with an attorney, CPA, and accounting team that understands your vision and the restaurant industry so that you can plan strategically for growth.
Contact The Fork CPAs if you want to work with a Controller who understands your unique goals in the industry.
