Section 1202 allows you to sell a qualified small business corporation (QSBC) on a tax-free basis.
Now, add to this no-tax-on-sale benefit to the 21 percent corporate tax rate from the Tax Cuts and Jobs Act, and you have a significant tax planning opportunity.
Imagine this: You sell your C corporation. The sale produces a $6 million capital gain to you.
Your federal income tax bite on the $6 million of gain is zero. Yes, you are awake. You are reading this correctly. The tax bite is zero.
Internal Revenue Code Section 1202 establishes the rules for the zero tax bite. To get to zero, you need to operate your business as a tax code-defined QSBC.
You may already have a tax code-defined small business corporation, or you may be thinking of starting a new business as a small business corporation. Paying zero taxes on the sale of your business stock is a big incentive.
100 Percent Gain Exclusion Break (Tax-Free Capital Gains)
To qualify for tax-free capital gains, you must acquire your QSBC stock after September 27, 2010.
More Than Five Years
Of course, there’s more than one rule. You must hold your QSBC stock for more than five years to qualify for the tax-free treatment.
Limitations on Excludable Gains
Your beloved lawmakers impose limits on your tax-free capital gains from the sale of a particular QSBC. In any taxable year, the tax limits on your eligible gain exclusion may not exceed the greater of:
- 10 times the aggregate adjusted basis in the QSBC stock you sell, or
- $10 million reduced by the amount of eligible gains that you’ve already taken into account in prior tax years from sales of this QSBC stock ($5 million if you use married filing separate status).
Example 1: $10 Million Limitation
You are a married joint filer. You invested $100,000 when you started your C corporation in 2012.
Now, in 2019 (more than five years after the start), you sell the stock in the C corporation for $6.1 million. You have tax-free capital gains equal to the greater of:
- $1 million (10 x $100,000), or
- $6 million (because it’s less than $10 million).
You have $6 million of tax-free capital gains.
Example 2: 10-Times-the-Basis Limitation
You are an unmarried individual. You invest $2 million in a single QSBC stock this year.
In 2025, more than five years from now, you sell this stock for $24 million, resulting in a total gain of $22 million ($24 million - $2 million). The tax code limits your tax-free gain to the greater of:
- $20 million (10 times the basis of the stock), or
- $10 million.
In 2025, you have $20 million in tax-free capital gains and $2 million in taxable capital gains. You have to be smiling.
Definition of QSBC Stock
To be eligible for the QSBC gain exclusion, the stock you acquire must meet the requirements set forth in Section 1202 of our beloved Internal Revenue Code. Those requirements include the following:
- You generally must acquire the stock upon original issuance or through gift or inheritance.
- You must acquire the stock in exchange for money, other property (not including stock), or services.
- The corporation must be a QSBC at the date of the stock issuance and during substantially all the period you hold the stock.
Next, you have to look at the rules that apply to the corporation. To qualify as a QSBC, the following rules apply.
Rules for the Corporation
The corporation must be a domestic C corporation.
The corporation must satisfy an active business requirement. That requirement is deemed satisfied if at least 80 percent (by value) of the corporation’s assets are used in the active conduct of a qualified business.
Beware. Qualified businesses do not include:
- the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other business where the principal asset is the reputation or skill of one or more of its employees;
- banking, insurance, leasing, financing, investing, or similar activities;
- farming (including raising or harvesting timber);
- production or extraction of oil, natural gas, or other natural resources for which percentage depletion deductions are allowed; or
- the operation of a hotel, motel, restaurant, or similar business.
The corporation’s gross assets cannot exceed $50 million before the stock is issued and immediately after the stock is issued (which considers amounts received for the stock).
We did not cover all the rules that apply but we wanted to give you a good handle on how this planning opportunity can work to your benefit. If you would like to spend some time with us going over the possibilities for you, please do not hesitate to reach out to your team at Luster Tax Consulting to work through this with you. Please use the following link to book your complimentary strategy call with your team at Luster Tax Consulting.