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Editorial 10 MIN READ

How to time a Delaware flip in 2021

Thirty months after our first pass, the §1202 clock still restarts at conversion, the CTA now layers a federal filing on top, and a new administration has threatened the exclusion by name

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. What a flip still is, in January 2021
  2. The §1202 clock, restated
  3. The political risk, priced in
  4. The CTA, starting next year
  5. §199A settled, and why it does not rescue the LLC
  6. The window in 2021, narrower than it was
  7. Rule of thumb
  8. Sources

Delaware flip in January 2021 is mechanically the same two-week project it was in July 2018, and the §1202 five-year clock still restarts on the day the Delaware C-corp issues stock. Three things around that spine have shifted since we last wrote this up in 2018, and all three push in the same direction: flip earlier.

The Corporate Transparency Act was signed into law on January 1, 2021, layering a federal beneficial-ownership filing onto the post-flip entity. The final §199A regulations settled in early 2019 and left most venture-track founders outside the deduction regardless. And the incoming administration campaigned on trimming §1202 for high-income taxpayers, which turns the clock from a tax-planning abstraction into a political one.

What a flip still is, in January 2021

The term of art has not drifted. A flip is the migration of a home-state LLC, S-corp, or occasionally a non-Delaware C-corp into a freshly chartered Delaware C-corp, done so an institutional lead can wire into the entity its partnership agreement was written to fund. The three paths are unchanged: a statutory conversion under 6 Del. C. § 265 when the source state has a cooperative outbound statute, a forward merger into a new Delaware shell when it does not, or a contribution of LLC interests for stock when the source LLC needs to stay alive under its current EIN for a license, a lease, or a lender consent.

Each path is governed federally by Rev. Rul. 84-111, whose Situations 1, 2, and 3 correspond to assets-up, liquidation-in-kind, and interests-over respectively. Provided the contributing members end up in "control" of the new corporation under IRC § 368(c) (80 percent of total combined voting power plus 80 percent of each non-voting class) as incorporated by IRC § 351, each path is a tax-free exchange at the federal level. The full mechanical walk-through is in our April 2020 LLC-to-C-corp piece; the timing logic below assumes you have read it.

Venture activity collapsed briefly in late March 2020, recovered by June, and closed the year unusually hot. NVCA counted 8,023 U.S. venture deals in 2020 at a combined $156.2 billion, both figures above 2019 despite a pandemic quarter in the middle. Term sheets in the first weeks of January 2021 are closing at 2020 Q4's pace or faster. If you are reading this because you have a signed one on the desk, the rest of the article is operational; skip to the §1202 section and keep going.

The §1202 clock, restated

IRC § 1202 excludes from gross income gain on the sale of qualified small business stock held more than five years, up to the greater of $10 million or ten times the taxpayer's basis per issuer. For stock acquired after September 27, 2010 the exclusion is 100 percent, made permanent by the PATH Act of 2015 (Pub. L. 114-113, § 126). On a $20 million founder outcome after five-plus years of holding, the federal tax simply is not owed.

The rule founders keep rediscovering is when the five-year clock starts. It starts on the date the C-corp issues the stock. The LLC years do not tack. A founder who formed a Delaware LLC in 2017, operated through the pandemic, and flips today closes the §1202 window for the 2024 exit and opens it for the 2026 one. Every month of delay after the business has become venture-track is a month of §1202 the founder will not be able to buy back at exit.

Two §1202 gates still matter at conversion. The corporation's aggregate gross assets must not exceed $50 million immediately after issuance under § 1202(d)(1). For most seed-stage flips this is a non-issue; for a company flipping into a priced round that lands $40 million on the balance sheet the same week, the test has to be modeled carefully, and the ordering of the conversion relative to the subscription closing is the difference between clean QSBS and no QSBS at all. And the corporation has to be engaged in a qualified trade or business under § 1202(e); the disqualified categories are health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any business "where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees." Services founders who assume the flip buys them §1202 and never test the qualified-trade gate are the second-most-common failure pattern after blown §83(b) elections.

The political risk, priced in

Joe Biden's campaign tax plan, published during the 2020 campaign, proposed taxing long-term capital gains at ordinary rates for taxpayers with income above $1 million, and his tax advisors talked openly about narrowing §1202. The inauguration is tomorrow, January 20, 2021. The Senate will run 50-50 with Vice President-elect Harris breaking ties, and the reconciliation calendar means a tax bill could move in the fiscal-year budget window rather than requiring regular order. Nothing has been introduced as a bill yet, and the timing of any actual change is speculative.

What that means operationally: a §1202 clock started in January 2021 is running against a statute that may not look like §1202 in 2026. The five-year holding requirement is a baseline Congress could leave alone while capping the exclusion for high-income taxpayers, or grandfathering stock issued before a specified date, or tightening the qualified-trade gate. Founders who were planning to flip "sometime this year" and were casual about when should stop being casual.

The narrow case for waiting is limited to one scenario: a founder who is genuinely unsure whether the business wants institutional capital at all. A flip on speculation still trades a clean pass-through for double taxation to solve a problem the founder may not have, and the 21 percent rate under Pub. L. 115-97 § 13001 does not rescue a profitable services business that wants to distribute cash. For anyone with a priced-round pitch calendar on the books, the political risk argues for flipping on the early edge of the window.

The CTA, starting next year

The Corporate Transparency Act (CTA) was enacted as Title LXIV of the William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, Pub. L. 116-283, over President Trump's veto on January 1, 2021. The operative provision is § 6403, which amends Title 31 of the U.S. Code to require "reporting companies" to file beneficial-ownership information with the Financial Crimes Enforcement Network. A reporting company is, with exceptions, any domestic corporation, LLC, or similar entity created by a filing with a secretary of state. A beneficial owner is any individual who exercises substantial control or owns or controls at least 25 percent of the ownership interests. The required data points are full legal name, date of birth, residential or business street address, and a unique identifying number from a government-issued document.

FinCEN has not yet issued the implementing regulations, and the statute gives Treasury one year from enactment to do so. The reporting obligation takes effect on the regulations' effective date for newly formed entities, and existing entities will have a transition period (not less than two years from the effective date of the regulations) to file. For a company flipping in January 2021, the practical reading is: the Delaware C-corp you form today will file a BOI report with FinCEN under rules not yet written, probably in 2022 at the earliest and more likely in 2023.

The flip checklist gains one line. Beneficial-owner contact information for every 25 percent holder and every "substantial control" individual (a term the regulations will have to define) has to be collected at the time of conversion and kept current within one year of any change. Cap tables that were informal in 2018 cannot be informal in 2021. The law firm running the closing should be delivering a beneficial-owner data sheet alongside the §83(b) election and the updated cap table, and the company's registered agent should be prepared to field a Treasury subpoena that did not exist as a category before this statute.

§199A settled, and why it does not rescue the LLC

The final §199A regulations, T.D. 9847, were published in the Federal Register on February 8, 2019 (84 Fed. Reg. 2952), with a companion set of proposed regs on previously suspended losses and REIT dividends through regulated investment companies. T.D. 9847 finalized the basic operative rules for the 20 percent deduction on qualified business income: the taxable-income thresholds above which the wage-and-basis limits phase in, the specified service trade or business exclusion, the aggregation rules, and the mechanics of the W-2 wages and unadjusted basis tests.

The net effect for the founders reading this article is small. The 2021 inflation-adjusted thresholds under Rev. Proc. 2020-45 are $164,900 for single filers and $329,800 for joint filers. Above those thresholds, a specified service trade (which includes consulting, financial services, and any business where the principal asset is the skill or reputation of its employees) gets no §199A deduction at all. The SSTB definition in the final regs overlaps substantially with the §1202 disqualified-trade list, so a services founder who is already disqualified from §1202 is typically also disqualified from §199A at venture-scale income. The LLC structure is fine for a pass-through services business that stays below the thresholds and does not intend to sell stock. It is not a rescue path for a venture-track founder thinking about delaying the flip.

What settled §199A regs do change, at the margin, is the pre-conversion tax planning. The final regs confirmed that guaranteed payments and reasonable compensation are not qualified business income, which removes a small category of founder-friendly structuring that some pre-conversion LLCs had attempted. The net tax delta from a flip is more predictable in 2021 than it was in 2018, and the direction is still toward conversion for almost any venture-track path.

The window in 2021, narrower than it was

The window to flip still opens at the seed close and still closes at the Series A term sheet. Inside that window, a flip is a two-week project with a legal bill in the $3,000 to $15,000 range per our April 2020 LLC-to-C-corp piece, Delaware filing fees in the low hundreds (currently $214 for the Certificate of Conversion plus $89 for the Certificate of Incorporation under the Division of Corporations' fee schedule), and a four-to-six-week calendar runway that lets the §83(b) elections get filed on day 3 rather than day 28.

Three things narrow the window relative to 2018. First, pandemic state-office turnaround on the source-state side is worse than it was; California and New York have been the worst offenders through late 2020, and a statutory conversion that takes three business days end-to-end in 2018 can take three weeks in January 2021 if the source state is slow. Build slack into the calendar. Second, lender and landlord consents that were handled over a lunch in 2018 require three rounds of email in 2021, because the counterparties are working from home and their counsel is slower. Third, the §1202 political calendar argues against the old discipline of "wait for the trigger." The triggers still matter, but the cost of a slightly early flip in January 2021 is a month of double-tax exposure the founder almost certainly will not use, and the cost of a slightly late flip is a statutory change to §1202 the founder cannot reverse.

The §83(b) calendar is still the single most common expensive mistake. Every founder receiving restricted stock in the new Delaware corporation has 30 days from the transfer date to file the election with the IRS service center where the founder files, copy to the company, copy retained. There is no form. There is no fee. The failure mode is the calendar, and it has been the failure mode in every version of this article.

Rule of thumb

Flip when the seed round has closed and a Series A pitch calendar is on the books; if there is any reason to think the priced round lands in 2021 at all, do not wait for the term sheet, because the §1202 clock you start today is running against a Congress that has §1202 in the crosshairs and a CTA filing you will have to make either way.

Sources

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