As a business owner, you may know by now that the Tax Cut and Jobs Act of 2017 (TCJA) has triggered significant changes to the way business of all shapes and sizes are taxed. From the reduced 21% tax rate for C-corporations to the new Section 199A Qualified Business Income deduction for certain businesses taxed as pass-through entities, the tax planning landscape for our entrepreneur clients is very different today.
In light of all of these changes, a long ignored, dark corner of the tax code has the potential to come back to shine. In this article, we'll reintroduce Section 1202 and the capital gain exclusion for the sale of Qualified Small Business Stock (QSBS). Should you be asking your advisors, accountants, and attorneys how it might benefit you and your family?
Since the enactment of Section 1202 in 1993, owners of QSBS have received preferential tax treatment on capital gains when the stock is sold. Specifically, after meeting a minimum holding period of five years, the capital gains on QSBS are either partially or fully excluded, depending on the date it was acquired. In fact, QSBS sellers with shares issued after September 27, 2010 may never pay capital gains tax on the sale of their business. However, due to historically higher capital gains and corporate tax rates, coupled with the Alternative Minimum Tax, few business owners found it tax efficient and worthwhile to strive to meet the QSBS qualifications after looking at the totality of their income tax situation. Not anymore.
The recent fervor of interest in QSBS planning is due to the changes resulting from the TCJA, which permanently reduced the corporate tax rate to 21%. The permanent reduction in corporate tax rate, paired with the QSBS exclusion, has created some very unique planning opportunities for small business owners meeting certain qualifications.
How do you know if you’re a QSBS owner? Here are some general requirements:
If you are currently taxed as a pass-through entity but otherwise meet or foresee meeting the QSBS requirements, it may be advantageous to convert to a C-corporation and start the holding period requirement. There are tax-efficient methods from which a pass-through entity can convert into a C-corporation, assuming there is congruence with the other non-tax and legal reasons for the choice of entity.
While a pass-through entity or sole proprietorship may still provide owners with a sizable income tax advantages over the holding period compared to that of a C-corporation, after considering the impact of double taxation (even with the reduced corporate tax rate), entrepreneurs with a liquidity event on the horizon (five to seven years) may find this to be a very acceptable trade-off after considering the tax savings windfall from excluding from taxation the entire gain on a sale of their business. To the extent owners can limit their personal cash flow received from the business during this period, the overall tax benefits are even magnified.
Let’s look at an example of a small business, which would otherwise meet the QSB qualifications, converting to a C-corporation and meeting the five-year holding period in order to achieve the 100% QSBS gain exclusion in a sale after year five. All of the income is taken out by the business owner in the form of non-taxable distributions (pass-through) or taxable dividends (C-corporation) during the holding period. After year five, the business is sold and a significant capital gain is recognized because of the owner’s low tax basis and significant appreciation of the business over the holding period. As you can see in the results below for this scenario, the C-corporation and 100% QSBS gain exclusion yields tremendous overall income tax savings.
Taxation of pass-through vs C-corporation – Impact of 5-Year Holding Period & 100% QSBS Exclusion
| Pass-Through | C-Corporation | |
|---|---|---|
| Tax on year 1-5 income of $2MM | $592,000 | $420,000 |
| Tax on year 1-5 distributions ($2MM for pass-through; $1.58MM net of tax for C-Corporation) |
N/A | $376,040 |
| Total Tax on Income and Distributions | $592,000 | $796,040 |
| Tax on gain from sale of business of $5.8M ($6M less $200K basis) after year 5 |
$1,160,000 | $0 |
| Total tax over 5 year holding period | $1,752,000 | $796,040 |
The process and tax laws governing these type of transactions are complex, nuanced, and will be under a high degree of scrutiny by the IRS. It’s important to work with a knowledgeable, experienced, and credentialed team to evaluate if this opportunity fits the facts and circumstances of your business and, if so, to ensure the transaction meets all of the necessary requirements to be successful.
There is significantly more to understand and test to determine if a QSBS transaction will work for you. Our Sanderson clients can count on us to quarterback the process with other professionals to ensure comfort in their transaction and alignment with their other estate and wealth planning objectives.