Qualified Small Business Tax on Sale of Stock
Depending on how you plan on selling your stock, you may be eligible to take advantage of the qualified small business tax on sale of stock. If you are, you’ll need to know the limits on how much gain you can take advantage of. Also, you’ll need to know the different options you have for taking advantage of Section 1202’s gain exclusion.
Limitation of gain to be taken into account
Having the ability to exclude the gain of your sale of qualified small business stock is a valuable tax break. However, there are some requirements that must be met in order to qualify for this exclusion.
The IRS has not formally promulgated regulations on the qualified business category, which can create uncertainty for taxpayers. Taxpayers must look to case law for guidance on their status.
The qualified small business stock exclusion is provided by section 1202 of the Internal Revenue Code. The section defines qualified small business stock as stock issued by an active domestic C corporation. The stock must meet certain requirements at the time of issuance.
Generally, the exclusion is limited to $10 million. There is also an annual limitation, which is $5 million. The gain is excluded from income only after the taxpayer has held the qualified small business stock for at least five years.
If the qualified small business stock is exchanged for another qualified small business stock, the taxpayer may roll the gain into another qualified small business stock within 60 days of the exchange. The basis of the converted stock is treated as the fair market value of the property exchanged on the date of conversion. The basis of the qualified small business stock may be adjusted by contributions to capital after the date of the original issue.
The qualified small business stock exclusion allows for a tax break of up to 100%. The limit of the exclusion increases to 75% before the end of 2010. This tax break encourages individuals to take a riskier startup decision. It is important to note that the QSBS umbrella does not include consulting services.
$50 million aggregate gross assets test
Having less than $50 million of aggregate gross assets is required to qualify for a qualified small business stock (QSBS) tax on the sale of stock. The $50 Million Test is an accounting calculation that includes the amount of cash used in capitalization, as well as the value of the assets that were contributed to the corporation in exchange for stock.
The $50 Million Test is not limited to C corporations. It applies to partnerships and limited liability companies. It is also a useful planning tool for corporations that have multiple business activities. For instance, if one company has two separate activities within it, such as a manufacturing and a software development business, it may make sense to break the company into two separate corporations.
The $50 Million Test also requires that the corporation have assets that are in trade or business, as well as those that are not contributed to the corporation. The assets that are in trade or business include cash and other property. The assets that are not contributed to the corporation include property that has been transferred to the corporation in exchange for stock.
A company may also meet the $50 Million Test if its gross assets increase quickly. For instance, if a company issues $50 million of stock in a single day, its assets will increase quickly to over $50 million. In this scenario, the tax authorities might argue that the $50 Million Test applies to two issuances, not just one.
While there is no guidance from the IRS regarding the exact number of assets required for the $50 Million Test, many corporations will fall under the threshold before and after stock is issued. Therefore, corporations should pay close attention to the $50 Million Test balance sheet.
Minority stock positions count against the 80% Test
Unless you’ve been living under a rock, chances are you have heard of Section 1202 of the Internal Revenue Code. As the name implies, the section limits the amount of gain a taxpayer may claim as a result of selling corporation stock in a given tax year. The section is not limited to domestic corporations; non-domestic subsidiaries and joint ventures are fair game. As a result, you may be in luck if you’re a major shareholder of a small, local firm. However, you may want to consult a tax professional for advice.
Section 1202 is not without its kinks. For example, taxpayers can claim a gain on the sale of stock that was bought with cash, but they can’t claim gain on a stock purchase that was paid in non-cash assets such as real estate or personal property. Also, the rule of thumb is that 10% of a corporation’s assets should not consist of real estate. You may also want to consider whether a stock purchase is a stock purchase or a stock distribution to partners from a partnership. This is especially important if the underlying assets are in limbo. A simple agreement for future equity might be treated as stock based on debt-versus-equity rules.
As far as a small business is concerned, Section 1202 has a knack for rewarding taxpayers who make smart investments in small businesses. As such, it’s no surprise that the rule of thumb is that the best way to save money is to buy from local firms. As a result, you might want to take a good look at the IRS’s small business tax calculator to see if you qualify for a federal tax break.
Redeeming stock exceeds $10,000
Using the QSBS exemption can help you avoid federal income taxes on profits when you sell your startup’s stock. But, before you start making plans for a tax-free sale, there are a few things you need to know.
The first thing you need to know is that QSBS stock can’t be held by a non-owner. This means that if you’re gifting stock, you’re not getting the tax benefits. The same goes if you’re redeeming stock from a related party.
To qualify for the QSBS tax benefit, you must have stock in an active trade or business. This is a broad category that includes businesses such as restaurants and hotels. The aggregate value of the assets used in this trade or business must be less than $50 million.
To get the most benefits from the QSBS tax benefit, you must buy your stock directly from the issuing corporation. This means that you can’t buy it from an investor or a holding company. Purchasing stock in a qualified small business can help you attract investors and raise capital, but it can also help you keep key employees in the company.
The second thing you need to know is that Section 1202 requires that the corporation issuing your stock is domestic. That means it must be a C corporation. In addition, the corporation must meet two gross-assets tests. The first test is to make sure that the company has no more than $50 million in aggregate gross assets. The second test is to make sure that the corporation meets the active trade or business requirements.
The QSBS tax benefit isn’t the only thing you can get from Section 1202. For example, you can exclude a minimum of $2,380,000 of gain from a sale of your qualified small business stock.
Options for claiming Section 1202’s gain exclusion
Using Section 1202’s gain exclusion on qualified small business tax on the sale of stock is a great way to avoid capital gains taxes. However, there are several important factors to consider.
Section 1202 was created in the Revenue Reconciliation Act of 1993 to provide targeted relief for small business owners and investors. The gain exclusion has been a popular option for founders, but the rules are complex.
The first step in determining whether your stock qualifies for Section 1202’s gain exclusion is to consult a tax professional. They can help you determine which entity is the best fit for your business. Then, you can request a private letter ruling to determine whether your stock qualifies.
Section 1202’s gain exclusion applies only to stock issued by a C corporation. It does not apply to S corporations or majority-owned LLCs. It also does not apply to gain on the sale of a partnership interest, gain from the sale of a partnership interest, gain on the sale of a non-domestic subsidiary, gain on the sale of a non-QSBS stock, gain on the sale of a non-QSBS joint venture, gain on the sale of a non-QSBS real estate, or gain on the sale of a non-QSBS interest in a real estate joint venture.
To qualify for Section 1202’s gain exclusion on the sale of QSBS stock, the taxpayer must hold the stock for at least five years before selling it. During this period, the taxpayer must have a qualified small business. During this period, 80% of the assets must be used in a qualified trade or business.
If the taxpayer’s qualified small business does not qualify, the taxpayer can reorganize in Section 368 and avoid the QSBS exclusion. The restructuring activity must fit within the Section 1202(h) exception for nonrecognition exchanges.