Sell your business and pay no capital gain: Qualified small business stock

by J. Christian Manalli, Partner, SFBBG

J. Christian Manalli is a partner in the Chicago law firm of Schoenberg Finkel Beederman Bell Glazer LLC. Manalli concentrates his practice on federal tax, estate planning, probate and general business matters. Manalli can be reached at 312- 648-2300, or by email at christian.manalli@sfbbg.com.

Many new business owners choose to form a pass-through entity when they start out. Limited partnerships, S corporations and limited liability companies electing to be taxed as partnerships or S corporations pass their income through to their owners without the entity paying federal income tax. By contrast, an entity taxed as a C corporation pays tax at the corporate level, and its shareholders likewise pay tax on income received from the corporation. However, few small businesses taxed as C corporations end up paying tax at the corporate level and get around the corporate tax by distributing all their income as compensation before year end.

A big advantage to forming a C corporation is Section 1202 of the Internal Revenue Code. Although Section 1202 has been around since 1993, in recent years it has become a powerful tax incentive for founders and start-up investors. Under Section 1202, qualified small business stock (QSBS) issued from a C corporation to original investors after September 27, 2010 can be sold for the greater of $10 million or 10 times the basis in the stock, whichever is larger, without incurring any federal income tax. You read that correctly: the first $10 Million (or 10x your basis) of gain is excluded completely from federal income tax.

As you might imagine, with a tax break this powerful there are complex requirements to adhere to both for the C corporation and the shareholder, and many traps for the unwary. In addition, the IRS has provided very little guidance and issued few rulings in this area, which can make navigating the rules tricky.

Requirements

Following is a short overview of the requirements:

• The company must be a domestic C corporation domiciled in the U.S.; however, the activity of that corporation or its subsidiaries can be domestic or international.

• The stock must be original issue stock. The stock must be purchased from the company directly and not from another shareholder. The stock can be purchased with property other than cash. In addition, stock received as compensation still meets the original issue requirement. While the stock doesn’t have to be issued as a part of the initial incorporation, stock that’s received in exchange for other stock is subject to additional requirements.

• The stock must be owned directly or indirectly by an eligible shareholder. Eligible shareholders can be any non-corporate shareholder (individuals, estates and trusts) and in some cases partnerships and S corporations. However, the owners of passthrough entities holding QSBS stock are subject to additional requirements.

• The eligible shareholder must hold the stock for at least five years prior to selling it.

• The company must be an eligible corporation when the stock is issued and during substantially all of the taxpayer’s holding period. An eligible corporation is any domestic C corporation or a limited liability company that has elected to be taxed as a C corporation.

• The company must have had less than $50 million of tax basis in its assets from August 11, 1993 through the moment immediately preceding the issuance of the stock. This means the company could be worth significantly more than $50 million if the basis in the assets is below $50 million. After the issuance of the stock the corporation will continue to qualify, even if its assets later exceed $50 million.

• An entity can be reorganized as a C corporation. However, assets contributed to a corporation in exchange for stock are measured by their fair market value at the time the corporation received the property.

• The corporation must use at least 80 percent of the fair market value of its assets in the active conduct of a qualified trade or business. This requirement must be satisfied during substantially all of the taxpayer’s holding period of the stock.

Although the above list of requirements may seem straightforward, in practice knowing how to comply and adhering to the rules can be difficult. If you are interested in learning more about Section 1202, please feel free to contact me.