Qualified Small Business Stock
Moving into its third year, the Tax Cuts and Jobs Act (TCJA) of 2017 remains relevant in terms of entity structure. One of the significant changes included in the TCJA was the reduction in the C corporation income tax rate to 21%, making the C corporation form of entity potentially more beneficial for business owners.
In addition to the lower income tax rate, C Corporation stock can potentially qualify as qualified small business stock (QSBS) under Internal Revenue Code Section 1202. Under this section, part or even all of the gain from the sale of QSBS can be excluded from income. There are specific requirements to qualify for this gain exclusion, including:
- The stock must be issued by a domestic C Corporation after August 10, 1993.
- The corporation must be a qualified small business with gross assets of $50 million or less at all times before and immediately after the date of issuance.
- The stock must be original issued stock rather than acquired from an existing shareholder.
- The corporation must be an active business, with at least 80% of the assets used by the corporation to conduct a qualified trade or business. Qualified trades or businesses do not include:
- Service businesses such as health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of its employees;
- Banking, insurance, financing, leasing, investing, or similar businesses;
- Farming businesses;
- Businesses involving the production or extraction of products, such as mines, wells, and other natural deposits; and
- Hotels, motels, restaurants, or similar businesses.
The amount of gain that can potentially be excluded from income depends on the acquisition date and holding period. QSBS acquired between August 9, 1993, and February 17, 2009, is eligible for a 50% exclusion, increasing to 75% for stock acquired between February 18, 2009, and September 27, 2010, and 100% for QSBS issued on or after September 28, 2010. To qualify for any exclusion, the stock must be held for a minimum of five years.
The amount of gain ultimately excluded is subject to the greater of two limitations– a cumulative limitation and an annual limitation:
- Cumulative Limitation – $10 million reduced by the aggregate amount of any prior Section 1202 gain.
- Annual Limitation – 10 times the aggregate adjusted basis of QSBS sold during the year.
The lower 21% tax rate offered to C corporations and the potential for 100% gain exclusion makes changing entity types worthy of consideration. However, it is important to note the major qualifications and considerations:
- The stock must be original issued stock. By definition, the conversion of an S Corporation to a C Corporation will not meet this definition since the stock was originally issued by an S Corporation. However, converting a partnership to a C Corporation could qualify since a partnership does not issue stock.
- The stock must be held for five years. If there is the potential for a stock sale in the near future, the gain would not be excluded.
- The stock is expected to appreciate in value substantially. Since C corporations are subject to double taxation (once at the entity level and again when the funds are distributed to the shareholders), the amount of gain to be excluded can overcome this double taxation. Additionally, the TCJA established a qualified business income deduction for pass-through entities of up to 20%. Again, if the potential gain exclusion is significant, this could overcome the loss of this 20% deduction.
- Potential changes in income and capital gain tax rates. The decision to convert to a C Corporation could be impacted by any upward revisions to income and capital gain tax rates. This is especially relevant in the 2020 election year.
Taxpayers A and B form a new entity, investing $2,000,000 (50/50 members). The business is expected to earn $100,000 each year over the next five years, and the owners will receive distributions of the same amount. After five years, the value of the entity has increased to $5,000,000 and will be sold for that amount. How would the choice of entity impact the taxation to the members? For simplicity purposes, state taxes have been ignored for this example but should be considered in the final decision.
If the entity is formed as a limited liability company (taxed as a partnership), both members would be allocated 50% of the profits, or $50,000 each year. Assuming both taxpayers are in the highest tax bracket, and qualify for the full qualified business income deduction, the tax on this would be $14,800 each year at a tax rate of 29.6%. The distribution of the funds would be a tax-free event since there is sufficient basis available. When the entity is ultimately sold for $5,000,000, the members would each recognize gain of $1,500,000 and would incur tax of $300,000 at the highest 20% capital gains rate.
Instead, what if the entity was formed as a C Corporation? The entity itself would pay tax on the annual income of $100,000, which would be $21,000 each year at a rate of 21%. After payment of corporate level income tax, income of $79,000 will remain to distribute. The members will be taxed on the annual distributions of $39,500 each, which would be $9,401 at a rate of 23.8% (20% on the dividend distribution plus the 3.8% net investment income tax). Upon sale of the stock, the taxpayers will be able to exclude the full gain of $1,500,000 each.
The tax calculations for each type of entity are as follows:
|Member-level tax on earnings||$148,000||$0|
|Member-level tax on distributions||$0||$94,010|
|Member-level tax on sale||$600,000||$0|
Comparing the two scenarios above, the C Corporation structure will save $548,990 in total taxes. However, the tax savings ultimately depend on the sale of the entity. Without the sale and Section 1202 exclusion, the C Corporation structure would actually result in additional taxes.
Choice of entity is still a relevant decision to make and you should consult with your tax advisor to determine the best course of action.