Investors in small businesses around the country may be pleasantly surprised in the aftermath of tax season. Thanks to the recent extension of the Section 1202 of the Internal Revenue Code, small businesses stand to attract even more investors, due to a surprising long-term advantage: tax-free gains upon the sale of qualified stock.
In December 2015, a previous extension was made permanent by the Protecting Americans from Tax Hikes Act of 2015, or PATH Act. Under the revised provision, small-business owners and investors can now exclude 100% of any gain they realize from the sale of qualified small-business stock. The extent of the savings will depend upon the value of the stock, but collectively, investors across the country are poised to save millions.
Owners of qualified small-business stock have been able to exclude a portion of the gain for years, but the percentage of the tax-free exclusion has varied. Even during the times the exclusion was 100%, it was never permanent — making planning tricky and computations difficult. As a result, tax advisers sometimes considered the provision more of a hassle than a help. Now that the 100% exclusion is permanent, the tax benefit is more attractive to both those launching new enterprises and those seeking tax-advantaged investments.
Taking advantage of this tax-free gain begins with a critical first step: Businesses incorporating as C corporations, rather than opting to be limited-liability corporations or S corporations. As a result, the tax advantages of qualified small-business stock could breathe new life into the C corporation model.
In recent years, C corporations have fallen out of favor while the popularity of limited-liability companies has been rising, along with S corporations. Those pass-through entities grew in popularity as small businesses sought to avoid double taxation (C corporations must pay taxes on the profit the corporation has earned; that profit is also taxed when it is distributed as dividends to shareholders). In recent years, another barrier for C corporations had been low individual income tax rates. This disadvantage eroded in 2013, when higher-income taxpayers saw an increased marginal tax rate, phase-outs of exemptions and deductions, higher capital gains taxes and increased estate tax liability.
The permanent 100% gain exclusion provides a compelling reason for business owners to give the C corporation a more serious look as they establish a new business and plan for the future. Among the benefits: If an owner holds the corporate stock, all of the gains from the sale of the stock could be excluded from income. Also, because the exclusion applies to stock received by gift or inheritance, the interest in the business can be conveyed tax-free, making the tax advantage attractive to family-owned businesses.
As with any tax provision, there are a number of requirements beyond just establishing a C corporation. Other provisions include:
• The company must have $50 million or less in capital.
• Eighty percent of the value of the corporate assets must be used in the active conduct of the business or trade.
• The stock must be directly secured as an original issuance from the C corporation. This can include gifts or inheritance from the original acquirer.
• The stock must be held for more than five years.
• The business must be active in eligible sectors. Ventures involved in personal services, law, banking, finance, leasing, hospitality, health, farming or mining are not qualified.
For business owners, the tax break is a boon as they look toward long-term growth and funding strategies. Across the country, the 100% exclusion will be a big incentive to those infusing funds into small business, which could boost economic growth.
Business owners should consider the C corporation model right from the start if they wish to eventually benefit from this tax break. Trusted advisers — including investment advisers, accountants and lawyers — will play a critical role in advising businesses on this latest opportunity, and helping owners determine the right corporate model to choose.
Jennifer Friedman is a vice president at Wolters Kluwer's BizFilings, which provides online incorporation services for small businesses.
