Federal Tax Exclusion for Small Business Investment Here to Stay
IMGCAP(1)][IMGCAP(2)]When it comes to driving the U.S. economy, small businesses translate into big dollars.
According to the Small Business Administration, small businesses make up more than 99.7 percent of all employers and provide jobs for about half of the nation’s private workforce. Recognizing the value of investment in small business, Congress has long permitted some (or all) of the gain from the sale of qualified small business stock to be excluded from income.
Now, thanks to the Protecting Americans from Tax Hikes (PATH) Act, signed into law in December 2015, gain on qualified small business stock purchased any time after Sept. 27, 2010, is 100 percent excludible from income for federal tax purposes. And, unlike previous extensions, the exclusion is now permanent. For the first time, small business tax advisors can be confident that the 100 percent exclusion of gain is here to stay, at least until Congress gets serious about taking up fundamental tax reform.
The permanency of the 100 percent exclusion is welcome news for both the small business community and the nation’s economy as a whole. In recent years, Congress wanted to incentivize more investment in small businesses, and did so by progressively increasing the amount of the gain exclusion. When originally enacted, the Internal Revenue Code Section 1202 exclusion provided a 50 percent exclusion from income on gains on the sale of stock of a qualifying small business held by an investor for more than five years. While the exclusion amount gradually increased, to 75 percent and then to 100 percent, these higher exclusion rates were extended only on a temporary basis until now.
A Good Investment or Too Good to Be True?
Although this tax break has been available to small business owners and investors for years in one form or another, the amount excludable from income has varied. An exclusion of less than 100 percent often created more tax headaches than it remedied, so many practitioners did not encourage their clients to use this strategy. Also, the exclusion percentage was tied to the date on which the stock was acquired. Given the five-year holding period requirement and the fact that the qualified stock had to be acquired after Sept. 27, 2010, 2015 was the first year in which a taxpayer could have qualified for the 100 percent exclusion upon the disposition of stock. However, with the 100 percent exclusion now a permanent tax incentive, the use of qualified small business stock is likely to be much more popular with both small business owners and investors.
To take advantage of this exclusion, there are certain conditions that must be met. Like all things tax-related, the IRS definition of “qualified small business stock” can be complicated. For a small business stock to qualify under Section 1202:
• The business must be a United States C corporation with $50 million or less in capital.
• The stock must have been directly acquired as an original issuance from the C corporation (or via gift or inheritance from the original acquirer).
• The stock must be held for more than five years from the date of acquisition.
• Eighty percent of the value of the corporate assets must be used in the active conduct of business.
• The company must provide services in an eligible sector—those in personal services, law, banking, finance, leasing, hospitality, health, farming or mining are not eligible for this exclusion.
There is a limitation on the amount of excludable gain. An investor disposing of qualified small business stock (meeting the criteria detailed above) is eligible to exclude the greater of either 10 times of their adjusted basis in the stock or $10 million.
Asking the right questions and exercising due diligence is crucial to determining whether an investment will allow the investor to take advantage of the 100 percent gains exclusion. But, with careful planning, small business owners and investors should be able to take advantage of the tax break.
It should be noted that while some states follow the federal tax treatment for qualified small business stock, others have their own set of rules. So, it is important for investors to find out whether or not their state provides a benefit for any qualified small business stock gains.
Tax-Free Gain as a Factor in Choice of Entity
In recent years, many small businesses have chosen to operate as LLCs (limited liability companies) or S corporations, rather than as C corporations. The specter of “double taxation” on amounts paid as C corporation dividends, combined with low individual income tax rates, tilted the scale toward these pass-through entities. However, the 100 percent gains exclusion is now giving entrepreneurs a compelling reason to consider the C corporation when setting up their businesses.
Although there are many tax and non-tax reasons to examine before incorporating, the 100 percent exclusion of gain provides several planning options that can make operating as a C corporation appealing. First, if the owner holds the stock, all the gain on the sale of the business may be excludable from income. Second, the provision provides excellent succession and estate planning opportunities.
This tax break is preserved if the stock is transferred by gift or upon death, making the business easily transferable to children or other family members.
Additionally, a business owner can use stock to compensate key employees or to attract talent; making them shareholders will provide them with tax-free income. Finally, if a business is experiencing growth and wants to attract investors to help support the expansion, the ability to offer tax-free gain is a good incentive. Accounting professionals are well positioned to help customers evaluate the pros and cons of incorporation. Plus, there are many tools that advisors can use to help their clients evaluate different entity structures.
Many small business owners lean toward forming an LLC because this type of entity offers the limited liability of a C corporation as well as pass-through tax treatment. For business owners who wish to limit ownership to only a few shareholders, or who wish to use the qualified stock as part of a succession or estate planning strategy, operating as a “close corporation” might streamline and simplify state recordkeeping requirements. Many states allow a corporation to be formed as a close corporation, which allows a company to streamline and simplify management and state recordkeeping requirements.
However, many outside investors prefer to invest in C corporations that are not close corporations, so it is important to understand the business owner’s long-range funding strategies. Working with an incorporation expert can simplify and expedite the formation process and help ensure all legal requirements are met. Partnering with a third-party provider can help the business owner stay in compliance with ongoing state requirements.
The 100 percent exclusion is a step in the right direction to encourage investment in small business ventures and facilitate economic growth. Small businesses can maximize their growth potential and gain a larger volume of investors by understanding how to capitalize on this provision. However, as with any opportunity, there is risk associated with this type of investment. Trusted advisors will play a critical role in advising both companies that wish to take advantage of these tax developments and investors who wish to invest in small businesses across the country.
Jason Erb is a lawyer and entrepreneur, and director of strategic alliances for small business at Wolters Kluwer’s CT Corporation, a provider of business formation, compliance, and registered agent services, including CT Incorporation Wizard. Jason helps small businesses, and the providers who service them, build their companies by securing and leveraging strategic partnerships in the areas of compliance and governance. Mark Luscombe, a CPA and attorney, is the principal federal tax analyst for Wolters Kluwer Tax & Accounting, whose products include CCH IntelliConnect, and is a key member of the company’s tax legislation team. He is the current chair of the Important Developments Subcommittee of the Partnership Committee of the American Bar Association Tax Section and regularly speaks on a wide range of tax topics.