Tax-Saving Opportunities for Investors in Qualified Small Businesses
By Cesar Estrada, Partner, Tax & Business Services
One of the most critical decisions that entrepreneurs must make is choosing the proper structure for their startup company. Ideally, the preferred structure should be tax-efficient so that these savings can be used for growth or distribution to the owners. When evaluating tax efficiency, often the C corporation doesn’t have the same appeal as pass-through entities, as the former is subject to double taxation.
The Tax Cuts and Jobs Act, enacted in December 2017, increased the C corporation’s allure and lessened the double-tax blow by reducing the top federal corporate income tax rate from 35 percent to 21 percent. Yet there are other reasons beyond tax efficiency that may lead entrepreneurs to choose the C corporation as their ideal entity structure. One such reason could be to seek venture capital funding. Sections 1202 and 1045 of the Internal Revenue Code (“IRC”) provide two other advantages afforded to investors in C corporations whose stock constitutes “qualified small business stock” (QSBS).
For a stock to qualify as QSBS, it must be issued by a C corporation (with limited exceptions) on or after August 10, 1993. The corporation’s aggregate gross assets must not exceed $50 million at all times from August 10, 1993, through the date of issuance and immediately after (including the amounts received in the issuance). Also, at least 80% of the corporation’s assets must be used in the active conduct of a trade or business (other than specifically excluded activities).
If the above criteria are met, IRC Section 1202 may provide the valuable tax-saving opportunity to permanently exclude a portion or all of the gain realized on the sale of the QSBS from taxation. To qualify, the non-corporate shareholder must hold the QSBS for more than five years. The gain eligible for the exclusion is limited to the greater of $10 million or ten times the shareholder’s basis of the stock.
If the more-than-five-year holding period required to qualify for the gain exclusion is not met, IRC Section 1045 provides another option. This option is available to investors who sell their QSBS after holding it for more than six months. Such investors can defer being taxed on the gain if they reinvest the proceeds in replacement QSBS within 60 days of the date of sale. The amount of the deferred gain will reduce the basis in the replacement QSBS.
It is important to emphasize that to qualify as a QSBS the entity must be a C corporation on the date of issuance. Thus, an S corporation cannot meet this requirement by converting to a C corporation. IRC Sections 1202 and 1045 should, therefore, be an essential consideration when choosing the proper entity structure in the startup phase and before the execution of an exit strategy.
For additional information, please contact your Marcum tax professional.