A very common question we get is “how much tax will I pay on the sale of my business?” In fact, now with the upcoming tax reform, it’s likely about to get worse for small business owners. That’s because the proposed tax reform is expected tax small business owners at almost 40% on the gain in the year of sale of their business based on new income thresholds. Reform is likely to turn what previously would have been favorable long-term capital gain rates into ordinary income tax gain rates. This is extremely difficult for business owners since the sale is usually in preparation for retirement or other investments, but the owner will be losing a significant portion of the cash from the sale to the IRS.
So, what is we told you, if you set up the entity differently from the start, you could structure a tax-free sale of your business?
A lesser-known tax provision under IRC Section 1202 allows business owners to sell their business 100% tax-free up to $10M, just by meeting some straightforward requirements.
The main requirements for the tax-free sale of a business are:
- Own qualifying small business stock (QSBS);
- Acquire the stock after September 27, 2010;
- Hold the QSBS for more than 5 years;
Feeling overwhelmed by all of this information and want answers today?
Qualifying Small Business Stock for Tax-Free Sale
Qualifying Small Business Stock (QSBS) is stock of a domestic C-Corporation for an entity whose gross assets cannot have exceeded $50M at any time. The stock should generally be acquired by original issuance, gift, or inheritance. On original issuance, the stock should be acquired in exchange for money, other property, or services and the corporation must be a QSBC at the date of the issuance and during substantially all the period you hold the stock. The corporation must also meet the active business requirement by at least 80% of the corporation’s assets being used in the active conduct of the business.
Tax Treatment of the Business Sale Once Qualified
If the sale qualifies for tax-free gain under IRC Section 1202, then gain up to $10M or 10x the taxpayer’s basis are tax-free and any remaining gain is taxed at a 20% long term capital gain rates plus the 3.8% NIIT tax. Keep in mind that if the stock was acquired before September 27, 2010, the tax rate on excess gain is at a 28% tax rate and may have AMT tax implications.
Reporting the Tax-Free Sale of Your Business
The gain and exclusion from the sale should be reported on Schedule D and Form 8949. The IRS still not published guidance on timing or required content of additional reporting requirements, so it’s important to disclose the 1202 gain exclusion clearly and keep all supporting documentation to substantiate the tax position.
Supporting Documentation to Save of Business Sale
You’ll want to keep as much supporting documentation as possible to support the tax-free treatment. Often, when the IRS performs an audit, they come in three years after the return is filed and you will usually have forgotten the details of the return preparation. Some of the documents we recommend keeping are the articles of incorporation, share certificates, stock purchase agreement, and stock sale agreement. Additionally, best case scenario would be if the tax preparation firm who took the section 1202 tax-free position on the return is also experienced dealing with IRS controversy so they can assist in providing the support clearly and concisely to the IRS agent. This type of representation is usually cost-effective and increases the likelihood that it will be a quicker and more effective process to show the appropriate treatment to the agent.
Limitation on Type of Business Which Qualify for Tax-Free Sale
In addition to the limitation on the amount of gain, there are certain businesses that do not qualify for the tax-free gain. These businesses are 1) 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 2) banking, insurance, leasing financing, investing or similar activities 3) farming 4) production or extraction of oil, natural gas, or other natural resources for which percentage depletion deductions are allowed or 5) the operations of a hotel, motel, restaurant, or similar business.
Stock Acquired Before September 27, 2010
Stock acquired before September 27, 2010 does not qualify for the 100% gain exclusion, but may qualify for partial gain exclusion: 1) 50% gain exclusion for stock acquired after August 10, 1993 and before February 18, 2009 2) 75% gain exclusion for stock acquired after February 17, 2009 and before September 28, 2010. There are AMT tax consequences for stock that does not qualify for 100% tax-free gain exclusion and the tax rate on the gain not excluded is taxed at 28%.
The following chart provides details on the effective tax rate as a result of the partial exclusion:
|Date Acquired||Effective Tax Rate||AMT Preference Item|
|Aug. 11, 1993 to Feb. 17, 2009||14%||Yes|
|Feb. 18, 2009 to Sept. 27, 2010||7%||Yes|
|Sept. 28, 2010 to Present||0%||No|
Example of 100% Gain Exclusion
A taxpayer creates her business on July 10, 2011, and she contributes property in exchange for all issued shares. The value of the property contributed at the time of issuance is $200,000. Almost five years later, her business is worth $7M. If she sells her business before July 10, 2016, then her taxable gain on sale is at least $1,360,000 (($7M – $200k) x 20%). If she sells after July 10, 2016, then her tax liability will be $0.
Alternatively, if she sells after July 10, 2016 when her business is worth $20M, then the gain over $10M is taxed at long term capital gain rates.
Takeaways for Tax-Free Sale of Business
IRC Section 1202 may provide a substantial tax benefit for the sale of your business. Or, if you’re starting a new business, it may be a good reason to start your business as a C-Corporation. However, there are many limitations and requirements, not all listed in this article, so we recommend careful planning to maximize the benefit.
Want to learn about more C-Corporation tax benefits?
See our upcoming blog articles on IRC Section 1045 Rollover of Gain and IRC Section 1244 to claim a loss.