I recently wrote about one early aspect of estate planning for small business owners: choosing between a corporation and LLC for your business. Today, I want to discuss another early part of business succession planning that you might not have thought about: choosing a tax treatment for federal income tax purposes.
One of the first steps after establishing a business entity (like a corporation or LLC) is choosing how it will be taxed. The choices generally boil down to being taxed as a C corporation or some kind of pass-through entity, like a partnership or S corporation.
If you read most head-to-head comparisons between C corporations and pass-through entities, you’ll find that the C corporation often looks like a sure loser. After all, income in a C corporation is subject to double tax—once when income is earned by the corporation, and once when that income is distributed as dividends to the shareholders.
However, C corporations do enjoy some advantages over other types of entities. One of those advantages arises if your estate plan calls for selling your business. Normally, you would have to pay income tax on the difference between what you sell your business for and your basis in it.
But stock in some C corporations qualifies as qualified small business stock (QSBS), and as much as 100% of the gain from sales of such stock is excluded from income. This post provides an overview of that exclusion.
What is QSBS?
The Internal Revenue Code is notorious for having convoluted definitions replete with cross-references and definitions of definitions. The definition of QSBS exhibits this confusing structure. To simplify significantly, stock qualifies as QSBS if (among a few other requirements):
- It is stock in a corporation taxed as a C corporation,
- The corporation held less than $50,000,000 in assets when the stock was originally issued,
- At least 80% of the corporation’s assets (by value) are used in the active conduct of a qualified trade or business,
- The taxpayer acquired the stock when it was originally issued, not through a later exchange, and
- The taxpayer has held that stock for at least five years.
A “qualified trade or business” includes most types of business, but does not include:
- A service business in the fields of health, law, engineering, architecture, accounting, or any of several other fields;
- A banking, insurance, financing, leasing, investing, or similar business;
- A farming business;
- Certain mining and drilling businesses; and
- A business operating a hotel, motel, restaurant, or similar business.
The Benefit of QSBS
When QSBS is sold, some or all of the gain is excluded from income for tax purposes, depending on when the QSBS was originally acquired:
- If acquired between August 11, 1993 and February 17, 2009, 50% of capital gain is excluded.
- If acquired between February 18, 2009 and September 27, 2010, 75% of capital gain is excluded.
- If acquired after September 27, 2010, 100% of capital gain is excluded.
In any event, the exclusion is normally limited to $10,000,000 for QSBS in a single corporation. For most people, that amount is more than enough to exclude all their gain on the sale.
How Does the QSBS Exclusion Impact Your Estate Plan?
Whether electing to tax your small business as a C corporation is a good idea because of the QSBS exclusion depends on your particular facts and circumstances. In many cases, the double taxes you pay while operating the business as a C corporation will overshadow the QSBS exclusion when you sell it. You need to plan early to know how the exclusion affects your decision.
Of course, if you already own a small business taxed as a C corporation, then you will be happy to learn that you may qualify for this hefty tax benefit.
In any event, be sure to consult with a knowledgeable estate planning attorney to help you know how this and every other aspect of your business affects your estate plan.