Business owners are always looking for ways to structure the business to minimize both the tax cost of current operations as well as the tax cost associated with selling the business. An often-overlooked opportunity allows taxpayers to exclude from income $10 million or more of gain from the sale or exchange of “Qualified Small Business Stock.” The potential ability to exclude this large amount of gain from being taxed, along with the new lower 21% maximum U.S. corporate tax rate, warrants consideration when structuring or restructuring your business.
Qualified Small Business Stock: Five General Requirements
In general, to be “Qualified Small Business Stock” and qualify for the gain exclusion, the following criteria must be met:
- The entity issuing the stock must be a C Corporation.
- The corporation must have gross receipts of $50 million or less,
- The corporation must also have gross assets of $50 million or less (including the proceeds from the issuance of the stock), and
- Comply with certain reporting requirements to the IRS and shareholders
- The taxpayer acquiring the stock must not be a C Corporation.
- Generally, only individuals and trusts can take advantage of the qualified stock gain exclusion.
- However, gain from the sale of qualified stock acquired by a partnership or S corporation may also be able to be excluded to the extent the gain is allocated to an individual or trust and is attributed to an interest in the pass-through entity that was continuously held from the date the pass-through entity acquired the qualified stock until the sale or exchange.
- The stock must be held by the taxpayer for more than five years.
- The corporation must be carrying on an active trade or business for the entire time the taxpayer holds the stock.
- The stock must have been acquired by the taxpayer directly from the issuing corporation upon issuance for money, other property, or services performed for the corporation, and meet the other criteria described above at the time of issuance and at all times thereafter.
- The stock does not need to have acquired upon the formation of the company as long as it is acquired upon issuance of the shares directly from the corporation and the other criteria described above are met.
You may be thinking that, for years, advisors have been warning against structuring an entity as a C Corporation because, historically, they been viewed as tax inefficient since income earned by a C Corporation is potentially subject to double taxation. As a reminder, a C Corporation is subject to corporate-level income tax on the income it earns, and then potentially the second level of tax if that income is distributed to shareholders.
Given the current maximum C Corporation federal income tax rate of 21% (as opposed to the top individual federal income tax rate of 37%), the C Corporation structure has created some opportunities. For example, by taking advantage of the lower corporate income tax rate on income earned from operations, the corporation will have more of its after-tax income to fund operations and growth of the corporation. Alternatively, if the C Corporation does make a “dividend” distribution to its shareholders, the maximum federal income tax rate for dividend income is 15%. Therefore, the maximum combined federal income tax rate on C Corporation income distributed to shareholders is 36%; clearly not as tax inefficient as in the past.
Of course, you are probably thinking, it can’t be that easy — and you are correct. There are many factors that affect the ultimate effective tax rate paid. And each of these, such as the impact of the 20% deduction for qualified business income, research and development credits and others must be factored into the decision of benefits/determents of structure. It is also important to consider potential future tax law changes, such as an increase in corporate income tax rates. But, all said, when we factor in the ability to potentially exclude $10 million or more of gain from the sale or exchange of Qualified Small Business Stock in the future, the potential tax benefits absolutely need to be carefully considered.
Qualified Small Business Stock and S Corporation Planning
Some of you are probably wondering how to take advantage of this if you are currently operating as an S Corporation. S Corporation stock cannot be Qualified Small Business Stock and, therefore, it cannot be eligible for the gain exclusion. Even if an S corporation revokes its S Election, and thus is taxed as a C Corporation going forward, the existing outstanding shares of the S Corporation would not be Qualified Small Business Stock.
However, a planning opportunity is for the S Corporation to form a new wholly-owned C Corporation, and then contribute its assets and liabilities to the new C Corporation in exchange for C Corporation stock. Provided the Qualified Small Business Stock requirements are met, the newly issued C Corporation stock may qualify for the gain exclusion to eligible S Corporation shareholders.
In the right circumstances, the Qualified Small Business Stock exemption can provide significant tax savings to business owners. However, there are many factors that should be considered in connection with the determination if such a plan is appropriate for a particular situation. Even if a business decides to implement a structure to have Qualified Small Business stock, there are various compliance requirements that must be followed to realize the benefits. Given the significant possible permanent tax savings at stake, prudent business owners will certainly want to evaluate the potential benefits and detriments.
To learn if and how this tax benefit applies to you, contact your CPA.