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 to tax small business owners at almost 40% on the gain in the year of sale of their business based on new taxable 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 any business owner 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 if 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 qualified 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; and
- Hold the QSBS for more than 5 years;
To understand how this works, let’s take a look at some examples and how the IRS treats taxes regarding the sale of a business.
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What qualifies as a QSBC (Qualifying Small Business Stock)?
Qualifying Small Business Stock (QSBS) is the 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 real 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 business 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. If the corporation was not a QSBC at any time prior to the stock acquisition, then the stock can only qualify if it meets the above criteria at the time of acquisition. For example, if the corporation was formed in 2007 and sold its shares in 2012, the stock does not qualify unless it was a QSBC when acquired.
What is a 1202 Gain and How is it Taxed?
A gain or loss on the sale of stock is taxable income. If the sale qualifies for tax-free gain under IRC Section 1202, then gains up to $10M or 10x the taxpayer’s basis are tax-free and any remaining eligible gain is taxed at a 20% long-term capital gain rate plus the 3.8% NIIT tax. Keep in mind that if the stock was acquired before September 27, 2010, the tax rate on the excess gain is at a 28% tax rate and may have AMT tax implications.
If the stock is held for less than five years, then the entire gain is subject to taxation. However, if the stock is held for five years or longer, there is no additional tax on the gain.
How Do I Report a Sale of Qualified Small Business Stock (QSBS)?
The eligible gain and exclusion from the sale should be reported on Schedule D and Form 8949. The Internal Revenue Service still has 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.
Documents to Support Your Section 1202 Business Sale
You’ll want to keep as much supporting documentation as possible to support the tax-free treatment. Often, when the Internal Revenue Service performs an audit, they come in three years after the tax return is filed and you will usually have forgotten the details of the return preparation. Some of the documents we recommend keeping are:
- Articles of incorporation
- Share certificates
- Stock purchase agreement; and
- Stock sale agreement.
Additionally, the 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.
What Businesses are Excluded from Section 1202?
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 include:
- 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;
- Banking, insurance, leasing financing, investing, or similar activities;
- Farming business;
- Production or extraction of oil, natural gas, or other natural resources which allows applicable exemption percentage deductions;
- 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 Alternative Minimum Tax (AMT) consequences for stock that does not qualify for 100% tax-free gain exclusion and the tax rate on the eligible 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 of Stock Acquisition||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|
Maximizing the Section 1202 Gain Amount: A Real-Life Example
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 a Tax-Free Sale of Your 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.
Consult with an Experienced Tax Professional
At DiLucci, our experienced team of tax professionals is here to help you with your individual or business tax needs, including assistance with business investments as well as purchasing and selling a business or corporation.
- Our services include:
- Individual and business accounting
- Tax return preparation
- Internal Revenue Service (IRS) tax resolution
- Business bookkeeping
- Financial analysis
- Cashflow management
- Tax planning
As always, our tax advisors are here to help. Click here to schedule a consultation with our office and we’ll follow up with you promptly.