If your business is incorporated, when you sell your stock, the gain usually is taxed at 15% or 20%, depending on your tax bracket (which is based in part on the gain from the stock). However, if the stock is “qualified small business stock,” you may pay zero tax, regardless of your tax bracket.
What is qualified small business stock?
The tax law is very specific about the type of stock that qualifies for this special treatment. Here are the key rules for qualified small business stock (also called Sec. 1202 stock because of the section in the Tax Code that governs it):
- It must be stock in a C corporation.
- It must have been originally issued after August 10, 1993.
- The corporation must have total gross assets of $50 million or less at all times after August 9, 1993, and before it issued the stock. Its total gross assets immediately after it issued the stock must also be $50 million or less. When figuring the corporation’s total gross assets, you must also count the assets of any predecessor of the corporation. In addition, you must treat all corporations that are members of the same parent-subsidiary controlled group as one corporation.
- You must have acquired the stock at its original issue, directly or through an underwriter, in exchange for money or other property (not including stock), or as pay for services provided to the corporation (other than services performed as an underwriter of the stock). You can’t have received it as a gift or inheritance.
- The corporation must have been a C corporation during substantially all the time you held the stock.
- Within the period beginning 2 years before and ending 2 years after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from you or a related party. Also, within the period beginning 1 year before and ending 1 year after the stock was issued, the corporation cannot have bought more than a de minimis amount of its stock from anyone, unless the total value of the stock it bought is 5% or less of the total value of all its stock.
- The corporation cannot be engaged in certain businesses, including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, farming, mining, or operating a hotel, motel, or restaurant.
In effect, if your business is a C corporation in retail, wholesale, manufacturing, or technology, you’ve got a shot at owning qualified stock.
Then you have to hold it more than 5 years in order to reap the zero capital gains tax rate. And the excludable gain is limited to the greater of $10 million or 10 times your basis in the stock. If spouses each own shares in the company, the limit applies on the joint return (spouses can’t double the limit).
Because the gain on qualified small business stock is tax free where the 100% exclusion applies, it’s not taken into account for the 3.8% tax on net investment income.
Becoming an LLC
So it’s clear you have to be a C corporation when you issue the stock. But what if you later decide to become a limited liability company? In a private letter ruling, the IRS decided favorably on this issue. A C corporation here converted under state law to LLC status, continuing to be taxed as a C corporation. The IRS said that because the conversion was merely a change in form (in tax parlance an F reorganization), the initial shareholders could continue to treat their shares as Sec. 1202 stock eligible for favorable tax treatment.
Becoming a C corporation
Can you do the reverse? Start out as an LLC and become a C corporation with qualified small business stock? There’s no IRS guidance on this. However, some experts have speculated that it’s possible. The basis of the LLC interests would become the basis in the C corporation stock acquired in exchange for the assets of the LLC (a tax-free incorporation).
What about terminating an S corporation election to be a regular, or C, corporation? Arguably, the stock you acquired when you were an S corporation won’t qualify. Any additional stock issued when you terminate the S election and become a C corporation can qualify (assuming all the conditions discussed earlier are met).
Note: While the issuing company must be a C corporation, a C corporation cannot use the 100% exclusion for stock it owns; the exclusion is for individuals owning qualified stock directly (and, possibly, indirectly through a pass-through entity).
Sec. 1202 stock can be used in a number of ways to advance a business, including:
- Rewarding employees. Sec. 1202 stock given as compensation helps to retain employees without draining cash flow.
- Attracting investors. When seeking capital, investors may be induced to buy in when they realize investments can become tax-free returns.
Of course, owners that issue Sec. 1202 stock must recognize the dilution in their ownership interests.
If you own a C corporation or are thinking of starting one, talk with your tax advisor so you understand whether you hold Sec. 1202 stock. Then, when you make it big and sell off some or all of your shares, you’ll appreciate the considerable tax savings you’ll receive.