“I’m selling my business (which I’m very excited about), but how will my sale proceeds be taxed?”
We hear this question a fair amount after the initial excitement of selling a business wears off and a seller realizes that he or she is not going to receive the full “Purchase Price” because the Purchase Price will be taxed. With that said, sellers are always happy to close a transaction and receive large wire transfers in their bank accounts, but the purpose of this article is to describe a potential method to minimize taxes on sale proceeds and increase the amounts of those wire transfers.
We are publishing this post now because (i) it’s tax season and (ii) Congress recently reduced the corporate tax rate from a high of 35% to a flat 21% in the Tax Cuts and Jobs Act of 2017 (the “TCJA”). Since the passage of the TCJA, many business owners have considered forming as or converting to a C-corporation to take advantage of the lower rate. In addition to the lower tax rate, you might consider structuring your “small” business as a C-corporation to take advantage of a seldom used, but potentially valuable, provision of the tax code. Structuring your business as a C-corporation potentially allows you as the seller, assuming your stock qualifies as “qualified small business stock” (“QSBS”), to exclude 100% of (i.e., pay no tax on) the gain on the sale of your stock.
That’s right, you read the previous sentence correctly – pay no tax on the gain on the sale of your stock.
Before describing QSBS in detail, we want to clarify that we are not advocating that a business should “begin with the end (tax treatment) in mind” (shout out to Greg Curran’s “Begin with End in Mind” article), but we are advocating that you should be aware of this seller-favorable tax treatment.
Now, to QSBS details:
- Eligible Stockholders: Only non-corporate stockholders (i.e., individuals and, in certain circumstances, partnerships, S-corporations, and limited liability companies taxed as partnerships).
- Mandatory Corporate Form: Only C-corporations (i.e., no S-corporations and, obviously, no limited liability companies or partnerships because such entities do not issue stock).
- Original Issuance: The stock must be issued from the corporation to the stockholder in exchange for money or other property, or as compensation for services performed for such corporation. Thus, with a few limited exceptions, the stockholder must receive the stock directly from the corporation and not by a purchase from another stockholder.
- Conversion to C-corporation: Following up on the two (2) items directly above, stock that is acquired upon the conversion of a limited liability company taxed as a partnership to a C-corporation potentially qualifies as QSBS (on a prospective basis).
- Qualified Small Business: As of the date of stock issuance, the C-corporation must meet the following two tests to be a “qualified small business”: (i) aggregate gross assets not exceeding $50,000,000 at any time before the issuance of the stock or (ii) aggregate gross assets not exceeding $50,000,000 immediately after the issuance of the stock (determined by taking into account amounts received in connection with the issuance).
- Active Business: During the time that a stockholder owns the stock, the C-corporation must be an “active business”. The C-corporation is an active business if (i) at least 80% (by value) of the assets of such corporation are used by the corporation in the active conduct of one or more “qualified trades or businesses” and (ii) such corporation is an eligible corporation. “Qualified trade or business” means any trade or business, other than certain excluded types of businesses, including most service businesses (i.e., law, accounting, consulting, etc.), banking or insurance businesses, and hospitality businesses.
- Five-Year Holding Period: The stock must be held for more than five (5) years prior to the sale.
- Limit on Gain Exclusion: As always seems to be the case, there is a limit to the amount of benefit under the QSBS rules. The amount of gain for a stockholder that is eligible for exclusion cannot exceed the greater of (i) $10,000,000 or (ii) ten (10) times the stockholder’s total adjusted basis in the stock sold by the stockholder. However, even with the limit, the gain exclusion is still significant.
- Caveat: Any decision regarding the tax structure of a business will need a thorough analysis of many factors. The list of items above are general rules of QSBS. Each item above has additional elements that can alter the QSBS analysis, so seek counsel from your attorney and CPA to learn more about QSBS.
The QSBS rules can potentially save you a significant amount of money when you sell your business! Some of our clients have structured their businesses to benefit from the QSBS rules. If you have any questions about structuring for QSBS or whether your existing stock qualifies as QSBS, feel free to contact us (Jon Mills or Jim Pickle).