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This article was previously published as a blog post on the Michael Best & Friedrich LLP website on September 13, 2024. It is being updated to reflect passage of the One Big Beautiful Bill Act, Public Law No. 119-21, H.R. 1 (the “OBBBA”), which was enacted on July 4, 2025.

Background 
It has long been startup writ that U.S. entrepreneurs should form their company as a Delaware C corporation.[1]  For a lot of founders, this can be pretty good advice.  Among other reasons, VCs often prefer not to invest in pass-through entities (they do not want to be in a position to send investors K-1s and may have agreements in place prohibiting investments in pass-through entities), granting equity to employees in an LLC taxed as a partnership generally causes those employees to be viewed as “partners” rather than “employees” for tax purposes meaning they can no longer receive W-2 compensation and have to pay estimated taxes which can be confusing to rank-and-file employees, and, though C corporations are themselves taxed on their own income, that may not practically matter to a company operating at a loss with a business model of someday selling to generate a return.[2] 

Moreover, Section 1202 of the Internal Revenue Code of 1986, as amended (the “Code”), allows certain holders of qualified small business stock (“QSBS”) to exclude up to 100%[3] of the gain from the sale or exchange of said QSBS if held for more than 5 years,[4] provided that the amount of gain taken into account under Section 1202 is limited to the greater of $15M (indexed for inflation for taxable years beginning in 2027)[5] or 10x the adjusted basis in the stock sold,[6] which may significantly enhance the desirability of incorporating as a C corporation. 

1202 “Flip” Explained
But there is an alternative to immediately incorporating as a C corporation that has potentially lucrative benefits (subject, however, to the downside risks referenced below).  It involves starting out as an LLC taxed as a partnership and then incorporating as a C corporation[7] at a later date—for example, when a term sheet is received from a VC that sets the pre-money valuation for the company.   

The logic underlying this strategy rests on attempting to maximize the amount of gain that can be excluded under Section 1202 of the Code.  As noted above, the amount of gain excludible under Section 1202 of the Code is limited to the greater of $15M or 10x the adjusted basis in the QSBS sold.  In determining the 10x limitation, a basis rule—applicable solely for purposes of Section 1202 of the Code—provides that the basis of QSBS will in no event be less than the fair market value of property exchanged for the QSBS.  Given this basis rule, waiting to incorporate at a time when the fair market value of the LLC has increased will generally result in an increased basis for 1202 purposes since the basis in QSBS cannot be less than the value of the property contributed to the C corporation, which would generally include the LLC’s goodwill/going concern value at that time.  

So, if, following the incorporation of an LLC taxed as a partnership, a shareholder who previously held interests in the LLC has a 1202 basis in their QSBS greater than $1.5M (1/10 of $15M) and sells all of those shares, then that greater amount would apply, instead of the $15M hardwired cap, in determining how much gain is eligible for exclusion. 

Here is an example: 

• Two founders form a Delaware LLC taxed as a partnership with each founder owning 50% of the LLC.  On Day 1, the LLC has $100,000 of assets and no liabilities.   
• If the LLC incorporates on Day 1, then the basis of the QSBS held by the founders for 1202 purposes will be $50,000 each, and the 10x limit would be $500,000 for each founder, which would be less than the $15M limit if all their QSBS is sold in the same year. 
• If, instead, the LLC waits to incorporate and six months later receives a term sheet conditioned on the company incorporating as a Delaware C corporation and setting the pre-money valuation of the company at $20M, each founder would have a basis in their QSBS for 1202 purposes of $10M each (based on the pre-money valuation). 
• Thus, assuming all other requirements under 1202 are met, including the 5-year holding period, each founder would, upon exit, generally be able to exclude from gain in excess of their $10M 1202 basis up to $100M (10x the $10M 1202 basis in their QSBS). 

Thus, some founders may be better off from a tax perspective starting out as an LLC taxed as a partnership and incorporating at a later date, provided they can comply with all requirements under Section 1202 of the Code (including the 5-year holding period).[8]

Possible Downsides to the Flip Technique
The 1202 “Flip” is not a one-size-fits-all solution, however, and there can be negative consequences associated with waiting to incorporate, and it is important to work with qualified tax and venture counsel to assess which strategy makes the most sense.  Some potential downsides include the following: 

• The 1202 basis rule referenced above was enacted to ensure that no appreciation occurring prior to the incorporation is eligible for exclusion under 1202.  
  • So, in the example above, if the founders waited to incorporate until they received a term sheet showing a $20M pre-money valuation and then ultimately sold their QSBS for $11M each, the 1202 basis in their QSBS would be $10M, and they would each have just $1M of gain eligible for exclusion under 1202. The remaining unexcluded gain would generally be taxed at normal long-term capital gains rates (and also be subject to the net investment income tax). 
  • In that event, the founders would have been better off incorporating Day 1 since they would then have had a $50,000 basis in their QSBS for 1202 purposes and would be entitled to exclude all of the gain beyond their $50,000 1202 basis in their QSBS by using the $15M per-issuer limitation instead.[9]  
• The five-year holding period requirement does not start until the LLC is incorporated as a C corporation.[10] 
• The $75M aggregate gross assets test[11] counts the corporation’s cash and the 1202 adjusted bases of its property (which, as described above, would initially not be less than the fair market value of any contributed property).[12] 
• Founders accustomed to processes used for C corporations may find administration of LLCs taxed as partnerships—particularly in allocating equity to larger groups of employees—to be more complex.  
• Early funding of the LLC can complicate incorporations.  Care should be taken to work with a qualified CPA aware of this strategy to avoid surprises. 

Michael Best lawyers can help you and your co-founding team determine what is the right strategy for you and your new business.  Even if you choose to start with a C corporation, we think it important that you be educated about the potential benefits and risks of alternatives.