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The exclusion from gain for the sale of “qualified small business stock” was enacted to encourage investment is small businesses. Although the provision has been around since 1993, the amount that can be excluded has varied over time. Since September 27, 2010, the exclusion percentage has been 100 percent, but it was scheduled to drop to 50 percent at the end of 2013.
Thanks to the recent “tax extenders” legislation, the 100 percent exclusion remains in effect through the end of 2014. (See our blog, "Tax Extenders Legislation Contains Holiday Presents for Small Businesses" for a summary of other small-business friendly provisions that were retroactively extended for 2014.)
This exclusion provides an extraordinary opportunity for every small business owner who incorporates their business and holds onto the stock for at least five years. And, this is truly a family- business-friendly provision: If the stock is received from the original stockholder by gift or through inheritance, the tax break is preserved and the holding period is carried over.
The value of this exclusion can be significant if the company appreciates in value before the stock is sold, as the following example illustrates:
You invest in Really-Big Conglomerate, Inc. Five years later you sell your shares for a $200,000 gain. Assuming a long-term capital gains tax rate of 20 percent, you will owe $40,000 in tax on the sale. However, what if you invest in Little Start-up (a qualified small business) and five years later you sell the shares for a $200,000 gain. In this case, your tax bill on the sale is $0 (zero). You save, $40,000 in taxes. You may also avoid being in a higher income tax bracket as a result of the sale or avoid owing an additional 3.8 percent of net investment income tax, in addition to any other taxes you owe.
While the gain is 100 percent excludable, there is a cap on how much can be excluded in any given year. However, most dispositions of stock can be structured so that the limitations are not a significant factor.
This is tax law—so, of course, there are multiple caveats to every rule. In order to issue qualified small business stock, the business must:
Some types of businesses are specifically prohibited from the rule. The following types of businesses cannot qualify:
Again, this is the Internal Revenue Code, so nothing is every straightforward. Not every issuance of stock—even by a business that meets the type of business test will qualify for the exclusion of gain. Here are the basic rules. The stock must be acquired:
Once acquired, the original owner must hold the stock for more than five years from the date of acquisition. (But, remember—this is a family-friendly provision. The stock remains qualified small business stock and the original owner's holding period is tacked onto the holding period for those who receive stock by gift or inheritance.)
Tax-free gain sounds too good to be true. And, while it is true, tax considerations are only one factor to consider when choosing or changing the structure of your company. Here are some indications that indicate incorporating or switching to a C corporation could be a good strategy for your business.
It's time to talk over your options with a business adviser. Beginning in 2015, the 100 percent exclusion will drop back to a 50 percent exclusion of gain. And, when considering incorporation, it is essential that you choose to incorporate in a jurisdiction that offers the turn-around time required to complete corporate formalities before the exclusion rate drops back to 50 percent.
The incorporation experts at CT can help ensure that the deadlines for forming your corporation and issuing stock are met. And, if you are operating as an LLC, we are ready to help you with your necessary conversion paperwork.
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