With long term capital gains tax rates up to 20% or more[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1], forming a startup as a C corporation requires special consideration given the dual tax consequences. Forming a C corporation may make sense, however, if it is a qualified small business (QSB) under Internal Revenue Code (IRC) Section 1202. A C corporation qualifies as a QSB if it has gross assets of $50,000,000 or less upon the initial stock issuance. The Protecting Americans from Tax Hikes Act of 2015 (Pub. L. 114-113) (PATH Act) made permanent the income tax exclusion of sale proceeds of original-issue stock of a QSB that is held for five years or more.
Startup Structures. Startups are usually formed as an S corporation, limited liability company or partnership (Pass Through Entities) to avoid the double taxation of the C corporation. C corporations are taxed at the corporate level and then again at the shareholder level, making the company owners’ potential tax liability a combined 50-60%. Pass Through Entities, on the other hand, are only taxed at the individual shareholder level on the company’s gain, with little to no corporate tax.[2] IRC Section 1202 was meant to encourage certain businesses[3] by providing that no tax will be imposed on the greater of $10,000,000 of gain or 10 times the shareholder’s adjusted basis in the QSB stock provided that the qualifying original-issue QSB stock has been held for five years before the stock sale.
QSB Stock. To qualify for IRC Section 1202 treatment, the corporation must be actively operated and its assets, upon formation, must be less than $50,000,000. Additionally the stock that is being sold must be:
Ownership of stock that qualifies for IRC Section 1202 exclusion is not restricted to individuals and may be by a Pass Through Entity or trust. The five year holding period is a long time in the world of startups, but that is ameliorated by allowing the exclusion to be transferred to others through tax-free transfers, such as inheritance, gifts or reorganizations. Thus, in these instances, your heirs or the subsequent stock owners may enjoy the benefits of the tax exclusion of IRC Section 1202.
With startups, it is almost impossible to predict the future and determine how well your venture will succeed and if its success will continue for five years. While IRC Section 1202 benefits are important to consider, it should also be kept in mind that C corporations may be less advantageous for owners and investors as yearly profits are taxed at the corporate level at corporate rates and losses stay with the corporation. Startup owners and investors usually prefer to be able to claim the entity’s losses in the initial years to offset their other income. With a C corporation losses may be carried forward at the corporate level to reduce corporate gain upon sale.
Sometimes, however, a startup is well poised for financial success and has an established set of owners/investors who will hold their stock for five or more years, who do not need the yearly losses, and who recognize that the eventual sale/transfer price of the company will substantially exceed their initial investment. In these instances, C corporation shareholders might take advantage of the substantial benefits of IRC Section 1202 to avoid capital gains tax.
The IRC Section 1202 exclusion from gain and tax was made permanent on January 1, 2016; shareholders utilizing it can enjoy the 100% exclusion of gains on the sale/transfer of stock for the foreseeable future. This exclusion is an important tool to inspire small businesses to form and prosper, encouraging the entrepreneurial ingenuity and grit that brings out the best of America.
Timothy Buynak, Partner
(Direct) 805.966.7575
www.BFASLaw.com
DISCLAIMER: This Advisor is one of a series of business, real estate, employment and tax advisories prepared by the attorneys at Buynak, Fauver, Archbald & Spray, LLP. This Advisor is not exhaustive, nor is it legal advice. You should discuss your particular situation with us or with your own attorney. Our legal representation is only undertaken through a written engagement letter and not by the distribution of this Advisor.
[1] American Tax Payer Relief Act of 2012 (Pub.L.112-240). Another 3.8% is added by the Net Investment Income Tax for certain income.
[2] California S Corporations have a yearly franchise fee that is the greater of $800 or 1.5% of income (profit) yearly. Limited liability companies are subject to a minimum $800 franchise tax plus an LLC fee if total income is greater than $250,000.
[3] Certain types of service industries are restricted from using IRC Section 1202; these include health, law, accounting, banking, hospitality, farming, and real estate services.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]
