Startups and the OBBBA: Rethinking C corporation vs. passthrough

Editor: Jeffrey N. Bilsky, CPA

Every startup begins with a handful of questions, and one of the most consequential is deceptively simple: What entity should we choose? That decision shapes how capital is raised, how founder and investor economics play out, how to design employee equity, and what the tax bill looks like upon exit.

For years, venture–backed companies defaulted to C corporations to unlock qualified small business stock (QSBS) gain exclusion under Sec. 1202, while bootstrapped or profitable businesses favored passthroughs to take advantage of the Sec. 199A qualified business income (QBI) deduction and manage self–employment tax, all while maintaining flexibility with exit strategies. The law known as the One Big Beautiful Bill Act (OBBBA), H.R. 1, P.L. 119–21, reset the table, as the corporate rate under the Tax Cuts and Jobs Act, P.L. 115–97, and Sec. 199A QBI deduction are now permanent, QSBS eligibility is expanded, and the transfer tax landscape is more generous. The result is a new calculus for entity choice, equity design, and exit timing.

Think about these options through today’s lens:

• A C corporation still aligns best with venture expectations and remains the only path to Sec. 1202. Compensation flows through W-2 wages, dividends are taxed at the shareholder level, and stock sales are typically cleaner for exits, even though double taxation can surface in certain transactions.
• An S corporation delivers passthrough taxation and potential for Sec. 199A benefits, but it demands reasonable W-2 compensation for shareholder-employees and adherence to shareholder eligibility and single-class-of-stock rules that can complicate financing.
• A partnership offers flexible allocations, potential Sec. 199A benefits, and basis step-ups on asset sales. However, operating agreements and capital accounts add administrative complexity.Courts have held that limited partners in limited partnerships are generally ineligible for the exception from Self-Employed Contributions Act (SECA) tax under Sec. 1402(a)(13) if they are determined to be limited partners in name only based on a functional-analysis test. Recent litigation has shifted the landscape: In Sirius Solutions, L.L.L.P., No. 24-60240(5th Cir. 1/16/26), the Fifth Circuit rejected the IRS’s interpretation of Sec. 1402(a)(13), holding that limited partners could qualify for the SECA exemption simply based on being a partner in a limited partnership with limited liability. However, the issue remains unsettled nationally, with appeals pending in other circuits and the potential for a split among the circuits on how “limited partner” should be defined for SECA purposes.
• Pre—venture capital (VC) fundraising is workable in a partnership, but it is less standard and can create friction when institutional money arrives.

C corporation considerations under the OBBBA

A wider QSBS regime under Sec. 1202 is one of the most meaningful changes under the OBBBA. The amendments to Sec. 1202 now reward more companies and offer more flexible timing. For stock issued after July 4, 2025, the aggregate gross–assets threshold of the entity rises from $50 million to $75 million, expanding eligibility for capital–intensive and fast–scaling businesses. The per–issuer lifetime exclusion cap increases from $10 million to $15 million (indexed for inflation beginning in 2027), while retaining the long-standing rule that the exclusion is equal to the greater of the dollar cap or 10 times the taxpayer’s basis in the stock. As a result, founders and early investors with substantial basis can materially exceed the nominal cap, particularly in capital-heavy or roll-up structures.

Most notably, the OBBBA introduces a tiered exclusion regime: a 50% exclusion for stock held at least three years, a 75% exclusion for stock held at least four years, and a 100% exclusion for stock held at least five years. For three– or four–year dispositions, the taxable portion is subject to the 28% capital gains rate and, potentially, the 3.8% net investment income tax (NIIT), yielding approximate effective federal rates of 15.9% (three years) and 7.95% (four years) if the NIIT applies. QSBS acquired on or before July 4, 2025, remains subject to prior rules and caps.

The core mechanics of stock awards and other property transferred in connection with performance of services remain unchanged: Founders must file timely Sec. 83(b) elections for restricted founder shares, document original issuance and active–business activities, maintain capitalization (cap) table hygiene, and avoid disqualifying redemptions near issuance. What has changed is exit math. Partial exclusions make earlier liquidity events even more viable, and modeling three– or four–year sales could meaningfully beat out waiting for five years, factoring in NIIT, state conformity, and the new $15 million cap.

Estate and gift planning now belongs in the same conversation, and it should start early. Beginning in 2026, the basic exclusion amount under Sec. 2010 is $15 million per person (indexed for inflation beginning in 2027), and portability remains in place. The OBBBA did not add new valuation-discount or grantor-trust limits, so familiar tools (e.g., grantor trusts, spousal lifetime access trusts, and grantor retained annuity trusts) can still move future appreciation outside the taxable estate, provided the arrangements are structured in a way to preserve Sec. 1202 original-issuance and active-business requirements. Please note that only nongrantor trusts are considered separate taxpayers for Sec. 1202 purposes and therefore can expand the per-taxpayer QSBS exclusion; grantor trusts are not separate taxpayers because the grantor is treated as the taxpayer.

The timing is powerful: Gifting founder shares or partnership interests before a major appreciation event can materially reduce future estate tax. Taxpayers should anticipate heightened scrutiny around transactions that can be viewed as indirect redemptions or disguised sales and should coordinate closely with tax, legal, and corporate counsel. Professional appraisals and contemporaneous documentation are essential; separating operating assets from passive holdings can also support defensible discounts where applicable. Taxpayers should think ahead about trust–level liquidity, basis tracking, and allocation of the QSBS exclusion. If an exit in three or four years is likely, taxpayers should consider building distribution and tax–management provisions into trust agreements so fiduciaries can execute without scrambling. Although the OBBBA does not add an explicit anti–stacking rule, multi–trust planning should assume heightened scrutiny, independent fiduciaries, and robust documentation (see Sec. 643(f)). State conformity varies significantly, which means taxpayers should consider domicile planning and keep an eye on whether a state conforms to Sec. 1202, as it can affect the entire outcome for the taxpayer. For example, New York conforms to Sec. 1202, whereas states including Alabama, California, Mississippi, and Pennsylvania do not. Taxpayers should evaluate whether their state of domicile has adopted Sec. 1202, including the changes effectuated by the OBBBA.

Passthrough considerations under the OBBBA

Passthrough economics remain highly relevant, particularly for services and bootstrapped businesses. With Sec. 199A now permanent, along with widened phase–in ranges and a modest minimum deduction for active small businesses, the deduction can be a durable part of a plan. S corporations must still pay reasonable W–2 compensation, and distributions in excess of wages typically avoid SECA tax. SECA exposure for owners remains a critical modeling point. As noted above, while the IRS has historically argued that limited partners are subject to SECA tax based on a functional–analysis test, the Fifth Circuit’s decision in Sirius Solutions, L.L.L.P., held that limited partners may qualify for the Sec. 1402(a)(13) exception simply by being a partner in a limited partnership with limited liability. Other cases, such as Soroban Capital Partners LP, T.C. Memo. 2025–52, 161 T.C. 310 (2023) (pending appeal decision in the Second Circuit), and Denham Capital Management, LP, T.C. Memo. 2024–114) (pending appeal decision in the First Circuit) — could produce a circuit split, leaving the definition of “limited partner” in flux. No statutory changes were made under the OBBBA, so taxpayers should continue to monitor how these cases develop.

The OBBBA’s adjustments to individual income tax rates and the state and local tax (SALT) deduction regime can significantly alter the after-tax economics of passthrough entities versus C corporations. For instance, many states’ passthrough entity tax (PTET) elections let partnerships and S corporations pay state income tax at the entity level (fully deductible by the entity for federal purposes), effectively restoring a SALT deduction that an individual owner could not claim due to the federal SALT cap. The OBBBA temporarily increases the SALT cap to $40,000 (2025–2029, reverting to $10,000 in 2030) and leaves PTET regimes intact. The passthrough versus C corporation gap may narrow or widen depending on owner income, the PTET rate, and whether the owner is subject to the SALT cap phasedown for taxpayers with modified adjusted gross income over $500,000 (increasing 1% per year from 2026 through 2029). Taxpayers should reassess compensation structures, distribution policies, and long-term reinvestment strategies in light of the revised landscape.

Exit planning and conversions

Exits and conversions continue to be highly structure–sensitive. Buyers often prefer asset purchases to obtain a basis step–up, while sellers prefer stock sales for rate benefits and simplicity. In the C corporation world, QSBS sales can be exceptionally income–tax–efficient under Sec. 1202, whereas asset sales risk corporate–level tax and a shareholder–level tax upon distribution or liquidation (double taxation). In partnerships, the sale of assets generally results in a single level of tax at the partner level, with the character of gain or loss determined by the nature of each asset sold. Gains from the sale of capital assets are typically capital, while gains from the sale of inventory or unrealized receivables are ordinary. Additionally, sales of partnership interests may be subject to Sec. 751, which can recharacterize a portion of the gain as ordinary income to the extent attributable to “hot assets” such as unrealized receivables and substantially appreciated inventory. Both asset sales and sales of partnership interests can result in state tax “leakage,” depending on the states involved and the character of the income recognized.

Trust ownership introduces additional layers of complexity to exit planning. Transaction documents should expressly address representations, indemnities, and post-closing distribution mechanics, and transaction models must account for taxation at the trust level and the allocation of income among beneficiaries. Where an entity conversion is being considered, a conversion from a partnership to a C corporation may be appropriate prior to a priced financing, with the understanding that QSBS eligibility generally resets with respect to post-conversion shares. Meanwhile, S corporations must carefully preserve S status and avoid inadvertent second-class-of-stock issues. Lastly, because state conformity to Sec. 1202 is uneven, residency and income-sourcing assumptions should be modeled early, as state-level outcomes can materially affect net proceeds.

To make these concepts concrete, picture two paths. In the first, a VC–bound product startup forms a Delaware C corporation; documents original issuance of stock and active–business status; uses clean equity instruments in equity–based compensation (e.g., incentive stock options and nonqualified stock options); files timely Sec. 83(b) elections; and avoids early redemptions. With the new three– and four–year partial exclusion tiers for QSBS and the $15 million (indexed for inflation beginning in 2027) cap, the team can forecast how liquidity needs and exit timing interact, while preserving the flexibility to wait for a full five–year exclusion. In parallel, the founders can establish nongrantor trusts to shift future appreciation, weaving QSBS–friendly provisions and an appraisal cadence into the governance framework, so estate planning supports rather than complicates the cap table.

The second path would be a bootstrapped, profitable services startup that runs the numbers on S corporation versus partnership economics under permanent Sec. 199A, modeling reasonable compensation and SECA exposure. If early gifting is planned, trust selection, discount defensibility, and state conformity will shape the strategy. The founder of a business organized as a partnership should keep the operating agreement and capital accounts disciplined, set distribution policies aligned with cash flow, and revisit the C corporation option if reinvestment needs or investor expectations change, especially now that QSBS rules apply more broadly and may support partial exits without the full five–year wait.

Implementation is where good plans become efficient, and defensible tax outcomes will depend on disciplined execution: QSBS records should be kept current, including proof of original issuance and ongoing compliance with the active–business requirement; S corporation shareholders should maintain contemporaneous reasonable–compensation analyses; and trust instruments and valuation reports should be prepared early and refreshed as facts and values evolve. Cap table integrity must be preserved, and state and franchise tax exposure should be tracked alongside payroll footprint and SALT–cap mechanics, particularly during 2025 to 2029. Where entity conversions are contemplated, transaction steps should be carefully sequenced to preserve eligibility and avoid technical traps.

A strategic decision

In a shifting policy environment, startups should treat entity choice as a major strategic decision rather than a one–time checkbox. Scenario modeling should address profitability timelines, fundraising paths, and exit horizons, all while tested under both the OBBBA’s enacted framework and potential future tax policy shifts. Early coordination among tax, legal, and corporate counsel is essential to avoid technical traps and preserve strategic optionality as facts evolve. Entity choice should be reevaluated at critical inflection points, from the onset of sustained profitability, and at pre–exit, while maintaining contemporaneous documentation to support all tax positions being claimed. In an evolving tax policy environment, proactive tax planning remains essential to achieving efficient and effective income tax outcomes for taxpayers.

Editor

Jeffrey N. Bilsky, CPA, is managing principal, Washington National Tax, with BDO USA, P.C. in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA, P.C.