As an entrepreneur and business owner, you’ve put a lot of time as well as your heart and soul into building your company. You also likely have much of your net worth tied up in the business. In fact, for many business owners their equity in the business represents the bulk of their net worth.
This means that enhancing the after-tax value from the business should be a central part of your liquidity planning and wealth management strategy. We emphasize after-tax because together federal, state, and local income taxes can in some cases erode about half of the owner’s proceeds.
There are many techniques that can be used to minimize the tax impact for business owners. One of the most powerful is the exemption for certain types of small business stock. In some cases, small business stock can be sold with little or no tax implications. Under Section 1202 of the tax code, qualified small business stock (QSBS) qualifies for significant tax breaks and can provide an excellent planning vehicle for the right business.
The current rules
The rules related to QSBS have evolved over time. The current rules have been in place since 2013, but keep in mind that Congress can—and has—changed the rules several times.
- The excludable gain from gross income is the greater of $10 million or 10 times the adjusted basis the shareholder has in the investment.
- The stock must have been issued by a U.S-based C corp. Other types of entities, including S-corps and LLCs, aren’t eligible. The stock must have been acquired via an original offering by the corporation, not as the result of a sale from a shareholder after this time.
- The corporation’s assets at all times on or after August 9, 1993 and before the issuance cannot exceed $50m. The gross assets immediately after the issuance must not exceed $50 million.
- The corporation must have been an active, operating company at all times during its existence. Holding companies aren’t eligible. The intent of the rules is to offer this tax break to companies engaged in a business, generally with assets and employees.
- Service businesses like a CPA firm, law firm or a financial advisor are excluded. Businesses engaging in farming, mining, hospitality, restaurants and similar industries are also excluded. This generally restricts the tax break to companies involved in manufacturing, distribution, retailing, technology and wholesaling.
- As part of the sale transaction, both the corporation and the selling shareholder will need to provide certain types of documentation for the transaction. This will include things like cost basis and other documentation to ensure the restrictions of Section 1202 have been met.
- The transaction must involve some sort of payment. This can be either cash or services provided in exchange for the stock. The exemption would not apply, for example, if the stock is gifted to another person.
- The acquisition date of the stock being sold matters.
- For stock acquired after September 27, 2010, if it is held for at least five years the entire gain is excluded from the seller’s gross income. There are no alternative minimum tax (AMT) implications either. If the stock is held for less than five years, the gain would be subject to capital gains taxes; if held for less than one year, the gain would be taxed as ordinary income.
- For stock acquired between February 8, 2009, and September 27, 2010, if it is held for at least five years, 75 percent of the gain would be excluded from gross income. AMT would apply on 7 percent of the amount of the gain.
- For stock acquired on or after August 11, 1993, but before February 8, 2009, if that is held for at least five years, 50 percent of the gain would be excluded from gross income. AMT would apply on 7 percent of the amount of the gain.
- Note: The above applies only to Federal taxes, some (but not all) states have related tax breaks for this type of transaction.
Why acquisition date is so vital
To illustrate how a QSBS transaction might work—and why the timing of when the stock was acquired is so important—let’s look at a hypothetical example. We’ll assume that the stock is sold on March 1, 2018, for a gain of $5 million and that all of the other QSBS qualifications listed above are met.
The table below shows how the tax treatment would vary depending on when the stock was acquired.
|Date stock acquired||Tax treatment|
|October 1, 2017||No exemption, gain is taxed at ordinary income tax rates|
|October 1, 2014||No exemption, gain is taxed at capital gains rate|
|September 28, 2010||Gain is fully exempt from gross income and no tax is due|
|February 9, 2009||75 percent of the gain is exempt from gross income; 25 percent is taxed at capital gains rates; 7 percent would be subject to the AMT|
|January 1, 1995||50 percent of the gain is exempt from gross income; 50 percent is taxed at capital gains rates; 7 percent would be subject to the AMT|
How we can help
If you’re an owner or executive of a relatively small C corp., you should take the QSBS rules into account as you move forward in developing your wealth management strategy. While the QSBS exemption probably wouldn’t affect your decision of whether to sell the stock, knowing about this exemption and whether you qualify can significantly influence what you could achieve with the after-tax proceeds from a liquidity event.
At Callan Capital, we have extensive experience guiding business owners through all aspects of their wealth management and liquidity planning. By taking the QSBS rules and other potential benefits of business ownership into account, we develop a customized plan for maximizing the after-tax proceeds generated by a liquidity event and turning that wealth into an enduring legacy for you and your family. Our team prides itself in coordinating the expertise of all of your advisors to ensure the best possible outcome.
If you have questions about how the QSBS exemption or other rules related to executive compensation could affect your wealth management strategy, please give us a call to discuss your situation..
Important Disclaimers: Callan Capital does not provide individual tax or legal advice, nor does it provide financing services. Clients should review planned financial transactions and wealth transfer strategies with their own tax and legal advisors. For more information, please refer to our most recent Form ADV Part 2A which may be found at www.adviserinfo.sec.gov. The tax information provided in this document is for general informational purposes only—it is not meant to be used, and cannot be used, by individuals to avoid federal, state or local tax penalties. Taxation varies depending on an individual’s circumstances, tax status and transaction type; the general information provided in this guide does not cover every situation—for complete information on your personal tax situation, you should always consult with a qualified tax advisor.
 U.S. Small Business Administration. https://www.sba.gov/blogs/qualified-small-business-stock-what-it-and-how-use-it