By: Carl T. Berry
For years now, conventional wisdom has been that, wherever possible, businesses should seek to operate as flow through entities (S corporations or partnerships) for income tax purposes. One rationale for this viewpoint has been, of course, that flow through structuring avoids the imposition of two levels of income tax (and avoids unfavorable corporate effective tax rates to boot). Flexibility has also been a driver. However, at the end of last year, new federal legislation retroactively revived and made permanent the 100% federal income tax exclusion for all gain on the sale of so called “qualified small business stock” (which may only be issued by domestic C corporations) under Internal Revenue Code Section 1202, if certain requirements are met. Prior to this change in law, this exclusion was only available for stock purchased in certain stimulus years following the great recession; far less generous beneficial tax treatment was generally available for “qualified small business stock” purchased after the stimulus years.
This recently enacted federal legislation should cause business owners or individual investors who may benefit from the qualified small business stock rules to examine more closely their choice of entity for any new formation and now give more serious consideration to utilizing a C corporation instead of a pass through entity. Some owners of businesses operating through existing flow through entities may also benefit from reorganizing as a C corporation so as to seek to take advantage of the change in tax laws.
The rules concerning “qualified small business stock” are complex, and this article will not describe them exhaustively. However, the primary potential benefit of the qualified small business stock rules is that if qualified small business stock was purchased after September 27, 2010 and is held for at least five years, any gain on the sale or disposition of the stock is entirely excluded from income (including for Alternative Minimum Tax purposes), up to an aggregate limit per shareholder, per issuer of qualified small business stock, of $10,000,000, or if greater, ten times the adjusted basis in the stock. In addition to individuals owning “qualified small business stock” directly, individuals owning indirectly through flow through entities may also benefit from the rules, a dynamic that may be of particular interest to smaller venture and private equity funds with primarily individual investors. Another important benefit of “qualified small business stock” is that even if the five year holding period is not met prior to a sale of the stock, the proceeds of the stock can potentially be reinvested on a tax deferred basis in new “qualified small business stock” within a 60 day time period, opening up the possibility of tax deferral to a slew of potential transactions which would ordinarily otherwise be currently taxable.
There are a number of requirements for a corporation to be able to issue “qualified small business stock,” including restriction on the types of assets and businesses that the corporation may own and conduct, an active business requirement, and limitations on the value of the corporation’s assets measured at the time of issuance of the stock (i.e., the aggregate asset value must be $50,000,000 or less as calculated under the applicable rules). “Qualified small business stock” may also generally only be acquired through original issuance of stock, which would be stock received directly from the issuing corporation and not as a transfer from another shareholder. Additional rules and potential pitfalls apply.
For more information about qualified small business stock rules, please contact your lawyer, or if you are not currently a client of our firm, contact:
Carl T. Berry (813) 227-7422
