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May 14, 2019

Planning for Qualified Small Business Stock Treatment: Back on the Front Burner

Please read important disclosures HERE

The Tax Cuts and Jobs Act passed at the end of 2017 sparked renewed interest by entrepreneurs, business owners, and employees of start-up companies in Section 1202 of the Internal Revenue Code (IRC). This section of the tax code allows taxpayers to exclude from their income 100% of eligible gains from the sale or exchange of “qualified small business stock” (QSBS) issued after September 27, 2010, and held for more than five years.

Only the stock of C corporations can be considered as QSBS. Income from a C-corp is taxed at the corporate level and any additional profits leftover that are distributed to shareholders (usually in the form of dividends) are subject to tax at the personal level. This concept is often referred to as “double taxation.”

The 2017 tax legislation cut the statutory income tax rate on C-corps from a 35% maximum rate under graduated rate provisions to a 21% flat rate. Double taxation still exists on the income passed to shareholders as qualified dividends. On qualified dividends, most taxpayers pay a 3.8% unearned income surtax in addition to a 15-20% capital gains rate. Therefore, for most business owners, the effective C-corp tax rate ranges from 36% (15% + 21%) to 44.8% (23.8% + 21%) on corporate income taxed at the corporate level and then distributed as qualified dividends. However, this rate is significantly lower than in prior years so setting up a business as a C-corp and having the stock be eligible for QSBC treatment has become more attractive for many business types.

In general, for stock to be considered as QSBS:

  • The stock must be from an eligible domestic C-corp acquired from the corporation at original issue in exchange for money, property (other than stock), or services;
  • The aggregate gross assets of the corporation (measured by adjusted basis) must not have exceeded $50 million at any time prior to the original issuance and must not exceed $50 million immediately after the original issuance; and
  • During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets must have been used in the active conduct of a qualified trade or business.

Qualified Trade or Business

A qualified trade or business means any trade or business other than:

  • A trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
  • A banking, insurance, financing, leasing, investing, or similar business;
  • A farming business (including the business of raising or harvesting trees);
  • A business involving the production or extraction of products of a character for which a deduction is allowable under IRC Section 613 (percentage depletion of mines, wells, and other natural deposits) or Section 613A (percentage depletion of oil and gas wells); and
  • A business operating a hotel, motel, restaurant, or similar entity.

Given that in the past, the number of taxpayers taking advantage of the IRC Section 1202 deduction has been limited, there is little case law elaborating on what is a qualified trade or business. Whether some businesses qualify may be subject to dispute until cases have been tested in the court of law.

Eligible Gain

Gain eligible for the exclusion (“eligible gain”) is limited to the greater of (1) $10 million (reduced by eligible gain taken into account during prior years) or (2) 10 times the taxpayer’s aggregate adjusted basis of the QSBS sold during the taxable year. The percentage of eligible gain excluded by section 1202 depends on when the shareholder acquired the QSBS. The gain exclusion is 50% for QSBS issued before February 18, 2009, and 75% for QSBS issued between February 18, 2009, and September 27, 2010. All eligible gain from the sale of QSBS acquired on or after September 28, 2010, is excluded from a taxpayer’s income.

Planning Opportunity

In certain circumstances, stock can be treated as having been received at original issuance even when the shareholder is not the original owner of the shares. If a person receives QSBS as a gift or from someone upon their death, the stock is treated as having been received by the transferee in the same manner as the transferor and retains the transferor’s holding period. If done properly, certain types of trusts to which QSBS is gifted may claim their own $10 million QSBS gain exclusion, separate from the grantor’s $10 million gain exclusion.

As with other complicated investments and transactions, a taxpayer should consider working with an integrated team of advisors (investment advisor, accountant, and attorney) who understand the rules and pitfalls of these options. If you would like more information on QSBS, please contact your estate planning attorney or B|O|S advisor.

Disclosure

It is the responsibility of any person or persons in possession of this material to inform himself or herself of and to seek appropriate advice regarding any investment or financial planning decisions, legal requirements, and taxation regulations which might be relevant to this topic and to his or her specific situation.

Opinions expressed in this article, which are not reliable as fact, are current as of 5/14/19 and are subject to change.

Filed under: Tax Planning

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