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Editorial 9 MIN READ

C-corp vs S-corp in mid-2021: the §1202 question under threat

The 21% rate is still 21%, the $10M QSBS exclusion is still law, and the Green Book proposes to cut both off at the knees

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 7 sections
  1. What §1202 actually says, unchanged since 2015
  2. The rate math, July 2021 edition
  3. The American Jobs Plan and the 28% proposal
  4. The May 28 Green Book and the §1202 narrowing
  5. What a founder should actually do in July 2021
  6. A rule of thumb that still holds
  7. Sources

he §1202 math still works in July 2021. A C-corp founder who holds qualified small business stock for five years can exclude up to $10 million of gain (or 10x basis, whichever is larger) from federal income tax. The rate on C-corp profits is still the flat 21% set by TCJA. And the American Jobs Plan wants to raise that 21% to 28%, while the Treasury Green Book released May 28 proposes to narrow §1202 so that high earners get only half the exclusion they get today.

None of that has passed. All of it is on the table. This is what the C-corp vs S-corp decision looks like in the narrow window between a law that still favors C-corps for founders on an exit path and a reconciliation bill that could change both sides of the equation before year-end.

What §1202 actually says, unchanged since 2015

Section 1202 of the Internal Revenue Code excludes gain from the sale of qualified small business stock (QSBS) held more than five years. For stock acquired after September 27, 2010, the exclusion is 100% of eligible gain, capped at the greater of $10 million or 10 times the taxpayer's adjusted basis in the stock. That 100% tier was made permanent by the PATH Act of 2015 (P.L. 114-113), which is why founders stopped asking whether it would sunset and started asking how to qualify.

The qualifying conditions are strict and have not moved. The issuer must be a domestic C-corporation. It must have had aggregate gross assets of $50 million or less at all times before and immediately after the stock was issued. The stock must be acquired at original issuance, in exchange for money, property other than stock, or services. The corporation must be engaged in a qualified trade or business, which excludes the usual list: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, hospitality, farming, mineral extraction, and any business whose principal asset is the reputation or skill of one or more employees. And the holder must keep the stock for more than five years.

Miss any of those and §1202 does not apply. An S-corp does not qualify. An LLC taxed as a partnership does not qualify. An LLC that converts to a C-corp qualifies only from the date of conversion, with the five-year clock restarting and the gross-assets test applied at the conversion moment. Founders who flipped from LLC to C-corp in 2016 are only now crossing the five-year line.

The rate math, July 2021 edition

Under current law, C-corp profits are taxed at 21% under IRC § 11(b), the flat rate enacted by the Tax Cuts and Jobs Act effective for tax years beginning after December 31, 2017. Qualified dividends to individual shareholders are taxed at 0%, 15%, or 20% depending on bracket, plus 3.8% net investment income tax for high earners. The integrated tax on distributed C-corp earnings for a top-bracket shareholder is therefore roughly 39.8%: 21% at the entity, then 23.8% on what's left.

S-corps pay no entity-level federal tax. Profits flow through to shareholders, who pay at individual rates, currently topping at 37% under TCJA. Active S-corp income is not subject to the 3.8% NIIT. An S-corp owner who qualifies for the §199A deduction can shave up to 20% off the effective rate on pass-through income, subject to the wage and UBIA limitations that kick in above the threshold ($164,900 single, $329,800 joint for 2021). The top marginal federal rate on fully qualifying §199A pass-through income is therefore about 29.6%, versus the 39.8% integrated C-corp rate.

On a cash-retention basis, the C-corp is still the worse vehicle for operating income that gets distributed. Keep everything inside the corporation, pay 21%, and reinvest, and the C-corp looks better. Exit through §1202 and it looks better still.

That is the entire case for a C-corp today. It rests on two numbers: 21% going in, zero going out on up to $10 million (or 10x basis) per shareholder per issuer. For a founder whose plan ends in a sale within five to ten years, and whose business is operational rather than a personal-service engine, §1202 swamps every other consideration. For a dentist or a solo lawyer, the analysis is inverted: the business probably will not qualify as a §1202 trade, and the S-corp payroll-tax play is the better one. We walked through the 2019 post-TCJA version of this analysis here, and the original pre-TCJA framing here. The spine has not changed. The threat model has.

The American Jobs Plan and the 28% proposal

On March 31, 2021, the White House released the American Jobs Plan, a roughly $2 trillion infrastructure proposal paired with a "Made in America Tax Plan" that would raise the corporate rate from 21% to 28%, impose a 15% minimum book-income tax on very large corporations, and tighten the global intangible low-taxed income regime. The 28% number is a split-the-difference between the pre-TCJA 35% and the current 21%.

A 28% entity rate changes the C-corp math materially. The integrated rate on distributed earnings for a top-bracket shareholder rises to about 45%, or 28% at the entity plus 23.8% on the remainder. That is a worse number than the fully qualifying §199A rate of 29.6%, and it matches or exceeds the unmitigated 37% individual rate. If the 28% passes and the §1202 exit is somehow preserved, the C-corp still wins for a founder on an exit path, because the exit tax goes from 23.8% to zero under §1202 regardless of whether the entity rate is 21% or 28%. The entity rate affects retained earnings, not the exclusion.

The 28% number is a Senate reconciliation target, not a bill. Senator Manchin has publicly floated 25% as his ceiling. The final rate, if there is one, is more likely to land in the 25% to 28% range than at either endpoint. Founders making entity-choice calls in July 2021 should assume the rate is going up but not assume by how much.

The May 28 Green Book and the §1202 narrowing

The threat that actually changes the C-corp case is in the Treasury Green Book released May 28, 2021, titled "General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals." Page 62 of the Green Book proposes to limit the §1202 exclusion to 50% for taxpayers with adjusted gross income of $400,000 or more, effectively rolling back the 100% tier that has been in place for stock acquired after September 27, 2010. The 50% exclusion would still apply to lower-income shareholders. The proposal would apply to sales and exchanges after the date of enactment, with a transition rule for binding contracts entered before.

Read literally, the proposal converts the QSBS exit for a high-income founder from a zero-tax event on the first $10 million of gain to a taxable event on $5 million of gain at ordinary capital-gains rates. Combine that with the Green Book's separate proposal to tax long-term capital gains and qualified dividends at ordinary income rates for taxpayers with more than $1 million in income (raising the rate on that income from 23.8% to 40.8% once the 3.8% NIIT is layered on), and the §1202 exit for a successful founder goes from 0% to roughly 20.4% on the first $10 million, from an effective zero-tax exit to something that looks a lot like a normal long-term gain.

The Green Book is not law. It is a disclosure document accompanying the President's budget, and historically a majority of Green Book proposals do not survive to enactment. The §1202 narrowing is also retroactive in effect for anyone who crosses the five-year line after enactment, which is a softer form of retroactivity than the capital-gains rate hike (the Green Book proposed an April 2021 effective date for that, which has drawn sharp criticism). A founder who sells before the date of enactment takes the current 100% exclusion. A founder who sells after takes the new rule.

What a founder should actually do in July 2021

There are three fact patterns where the decision is straightforward, and one where it is hard.

Straightforward case one: the operating business is a qualified §1202 trade (software, product, manufacturing, most consumer businesses), the founder expects a sale in five to ten years, and current cash distributions are not the plan. Form a C-corp, document the QSBS qualification contemporaneously, and start the five-year clock. The 21% rate may become 25% or 28%, and the §1202 exclusion may shrink to 50% for high earners, but the worst post-reform C-corp is still competitive with an S-corp for a founder on an exit path, and the best case remains a zero-tax exit on the first $10 million.

Straightforward case two: the business is a personal-service engine (law, consulting, medicine, financial services, brokerage) that §1202 excludes by statute. The C-corp gets you nothing on exit. An S-corp lets you take a reasonable salary, distribute the remainder free of payroll taxes, and potentially qualify for §199A below the threshold. The 2019 piece we linked above walks the numbers; nothing about the Green Book changes that calculus, because §1202 was never available.

Straightforward case three: the founder plans to keep the business indefinitely and distribute cash every year. An S-corp or an LLC taxed as a partnership is probably better. A C-corp that distributes annually loses the §1202 timing arbitrage, pays integrated tax that rises with any rate increase, and gets no §199A offset.

The hard case is the founder who is three or four years into holding QSBS and has not yet crossed five years. The §1202 exclusion vests at the five-year mark; sell earlier, and you're a §1045 rollover candidate at best. If the Green Book proposal is enacted mid-holding with a date-of-enactment effective date, a founder who hits five years afterward takes the 50% rule on any sale. There is no pre-emptive sale to lock in the current exclusion, because you don't have it yet. The practical response is to watch the reconciliation calendar, accelerate sale conversations if one is already plausible, and document QSBS qualification meticulously so the exclusion, at whatever percentage it survives at, is defensible on audit.

A rule of thumb that still holds

If the business is operational, the exit is on the horizon, and the trade qualifies under §1202, pick a C-corp; the 100% exclusion on the first $10 million may be at its peak value right now, and even a 50%-narrowed version still beats most alternatives. If the business is a personal-service engine or a cash-distribution vehicle, pick an S-corp or a partnership; §1202 was never going to help.

The Green Book is the first serious threat to the QSBS exclusion since 2010. Between now and the reconciliation vote expected in the fall, the 100% tier is still on the books, the 21% rate is still 21%, and a founder with a five-year horizon has one of the cleanest entity-choice answers the Code has ever offered. Whether that remains true in 2022 depends on fifty senators, one of whom is almost certainly going to be Joe Manchin.

Sources

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