Exclude 100% of your gains
For decades, the best tax structure for most small business corporations was an S Corporation. But proposed tax law changes could offer other options and usher in the new era of C corporations for small businesses.
An S corporation is a flow-through entity with all corporate taxable income taxed to the individual shareholders. A C Corporation is a separate taxpaying entity with residual corporate earnings passed through to shareholders in the form of dividends. With a C Corporation, earnings are first fully taxed inside the corporation and then, the residual distributed to shareholders, where it is taxed yet again.
A growing business will generally retain cash inside the corporation to finance expansion. If the owners of the corporation are in a high tax bracket, the S Corporation form of taxation will produce higher overall current tax on these earnings than a C Corporation because earnings can be reinvested inside a C Corporation, instead of being distributed to shareholders, allowing the business to utilize graduated corporate tax rates and a lower top marginal rate.
There is a tax provision that could be of great use in the era of low corporate tax rates - Sec. 1202. This law was enacted in 1993 and provided for a phased-in exclusion for capital gains related to certain sales of small business stock. This favorable tax provision was scheduled to expire at the end of 2010, but recent legislation has made it permanent.
The gain exclusion for Sec. 1202 was originally set at 50% for stock acquired on or after Aug. 11, 1993, increased to 75% for acquisitions after Feb. 17, 2009, and expanded to a full 100% exclusion for acquisitions after Sept. 27, 2010.
The 2010 law also removed of one of the main drawbacks of this tax provision - the alternative minimum tax preference.
In a nutshell, Sec. 1202 allows taxpayers (other than corporations) to exclude from federal income tax 100% of the gain from the sale of qualified small business stock (“QSBS”). The amount of gain excluded is limited to the greater of $10 million or 10 times the adjusted basis of the investment.
Stock must meet five criteria to be QSBS stock:
Acquired directly from a U.S. C Corporation;
Tax basis of assets of the C Corporation immediately before and after the issuance of stock does not exceed $50 million;
The C Corporation and shareholders must consent to supply documentation regarding the stock issuance;
The C Corporation must conduct an active trade or business with certain industries excluded; and
The stock must be held for five years.
The industries excluded from Sec. 1202 treatment are:
Performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees;
Banking, insurance, leasing, financing, investing, or similar businesses;
Production or extraction of natural resources; and
Hotels, motels, restaurants, or other similar businesses.
For example, Tom and Jane decide to start a software development business. They purchase stock for $10,000 each and have a 50-50 ownership interest in the C Corporation. The stock is eligible for Sec. 1202 treatment if held for five years. In six years, they sell the stock of the company to Google for $10 million. They each have a $4,990,000 gain on the sale of the stock and their tax on the transaction is zero.
Many small business sales are structured as asset sales rather than stock sales, and Sec. 1202 does not apply to asset sales. Most sales are negotiations, and purchase price allowances can be made to allow the seller to structure the transaction as a stock sale, thereby excluding all of the gain.
The 100% gain exclusion, coupled with a reduced corporate tax rate, may make the C Corporation form of operation favorable for some small businesses. This section of the tax code is complex, and if you decide to set up your business to take advantage of the Sec. 1202 exclusion, you should consult your tax adviser. Depending on the objectives of a business, this form of operation may make sense, and should be evaluated before pulling the trigger on an S Corporation election.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at firstname.lastname@example.org