Over the last couple of decades, entrepreneurship in the United States has grown significantly. According to the latest entrepreneurship stats, nearly 5.1 million new businesses were registered in 2022 alone. In 2021, the number of new businesses established hit a record high of 5.4 million. Below is a chart of the monthly total business applications since 2005 from April 2023.
With the recent boom in new businesses, we wanted to put together some ideas around tax planning ideas. One of the most important decisions to make is how your new business entity is structured. While this decision can be complex and should be individualized for each circumstance, we wanted to highlight in today’s article an area of the tax code that we can be beneficial for clients as they approach a potential sale of their business in the future.
Qualified Small Business Stock Tax Provision
As tax planning becomes an increasingly vital aspect of financial management, small business owners are constantly on the lookout for ways to optimize their tax strategies and maximize their savings. One significant opportunity that often goes unnoticed is the potential for substantial tax savings through the Qualified Small Business Stock (QSBS) tax provision. This provision, embedded within the United States Internal Revenue Code (IRC), offers eligible small business owners the chance to exclude or defer capital gains taxes on the sale of qualified stock.
The term “QSBS tax” refers to the Qualified Small Business Stock tax provision. It is a tax incentive provided under IRC Section 1202 that allows eligible taxpayers to exclude or defer the capital gains tax on the sale of qualified small business stock (QSBS).
Here are some key points to understand about QSBS tax:
- Eligibility: To qualify for QSBS tax benefits, the stock must meet certain criteria. The stock must be issued by a domestic C-Corporation that is classified as a “qualified small business” (based on its assets and operations). Additionally, the stock must be acquired directly from the company in exchange for money, property, or services.
- Capital Gains Exclusion: If you meet the eligibility criteria and hold the QSBS for at least five years, you may be able to exclude a percentage of the capital gains from the sale of that stock from your taxable income. The percentage of the exclusion depends on the acquisition date of the QSBS.
- If the stock was acquired after September 27, 2010, and before February 18, 2009, the exclusion is generally 75%.
- If the stock was acquired after February 17, 2009, and held for more than five years, the exclusion is generally 100%.
- Limitations and Restrictions: The potential tax benefits provided by QSBS are subject to limitations and restrictions. For example:
- The maximum amount of eligible gain that can be excluded is generally the greater of $10 million or 10 times the taxpayer’s basis in the QSBS.
- Certain industries, such as professional services (e.g., healthcare, law, engineering, finance, and hospitality), do not qualify for QSBS treatment.
- The stock must be acquired at its original issue, and certain rollover transactions or purchases from related persons may limit eligibility.
- Alternative Minimum Tax (AMT): While QSBS allows for the exclusion or deferral of capital gains tax, the alternative minimum tax (AMT) may still apply. The AMT is a separate tax calculation that eliminates some deductions, including the QSBS exclusion, to ensure that high-income individuals pay a minimum amount of tax.
S-Corporation Taxation vs C-Corporation Taxation
Imagine ABC Corporation has been operating as an S-Corporation for several years but decides to convert to a C-Corporation to take advantage of certain growth opportunities.
- S-Corporation Taxation: As an S-Corporation, ABC has been enjoying pass-through taxation. This means that the company itself does not pay federal income taxes. Instead, the profits and losses “pass through” to the individual shareholders, who report them on their personal tax returns. The taxation is as follows:
- Profits and Losses: The net income or loss of ABC is allocated to the shareholders based on their ownership percentage. Each shareholder includes their share of the company’s income on their individual tax return and pays taxes at their individual income tax rates.
- QSBS Exclusion: As an S-Corporation, ABC cannot directly issue QSBS. Therefore, it does not qualify for the QSBS tax exclusion.
- C-Corporation Taxation: After converting to a C-Corporation, ABC experiences a shift in its tax structure:
- Corporate Taxation: As a C-Corporation, ABC is a separate taxable entity. It is required to file its own tax return and pay taxes on its net income at the corporate tax rates.
- Shareholder Dividends: If ABC distributes dividends to its shareholders, those dividends are subject to individual income tax when received by the shareholders.
- QSBS Exclusion: As a C-Corporation, ABC can issue qualified small business stock (QSBS) directly to its shareholders. If certain requirements are met, eligible shareholders may be able to exclude a portion of the capital gains from the sale of the QSBS from their taxable income, potentially reducing their tax liability.
Example of Qualified Small Business Stock Tax Provision
ABC Corporation issued qualified small business stock (QSBS) to its shareholders. One of the shareholders, Joe, acquired QSBS for $100,000. After holding the stock for more than five years, Joe sold the QSBS and realized a capital gain of $1,000,000.
Due to meeting the QSBS requirements, Joe may be eligible for a 100% exclusion of the capital gain. This means he could potentially exclude the entire $1,000,000 from his taxable income, resulting in significant tax savings.
Remember, this example is hypothetical, and individual tax circumstances can vary significantly. It is essential to consult with a qualified tax professional or advisor for personalized advice based on your specific situation and the most up-to-date tax laws and regulations.
Presented by the Financial Planning Committee of Lake Street, an SEC Registered Investment Adviser
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Investing involves risk and you may incur a profit or a loss.
