Starting a new business can be overwhelming. Typically, a fair amount of attention will be devoted to financial considerations, both in terms of capital needs for opening and growing the business as well as retaining the economic profits that will ultimately arise. In regard to the latter, a business owner will often seek the advice of a tax professional. The owner’s focus is generally on the immediate outcomes; i.e., how to pay the least amount of taxes and, thereby, maximize the after-tax proceeds available to cover personal expenses and grow the business.

However, a longer view of the company’s lifecycle, including the potential consequences arising at the time of a sale, may not be best served by some short-term tax strategies. For instance, should your company be formed as a C Corporation or a pass-through entity (S Corporation or limited liability company)? While tax rates often fluctuate, C Corporation tax rates (currently a Federal flat rate of 21 percent) can be attractive compared to the individual tax rates that will apply for pass-through entities (currently about 29.6 percent, assuming the company can take advantage of the qualified business income deduction). Yet, the lower C Corporation tax rate is often only temporary as the tax consequences arising in the event of a sale of the business can materially overcome the prior economic benefit of lower taxes on operating profits.

Qualified small business (QSB) stock provisions of the Internal Revenue Code (IRC) can present a valuable tool to address the potential adverse tax implications at the time of sale. IRC Section 1202 allows a business owner to exclude a portion or the entire amount of gain realized from the sale of QSB stock held for more than five years. As with any tax benefit, the gain exclusion is available only if all requirements are met and is subject to limitations. When originally enacted, the gain exclusion was limited to 50 percent of gain, but it has been increased to 100 percent for QSB stock acquired after September 27, 2010. The gain exclusion is generally limited to the greater of $10 million or 10 times the aggregate adjusted bases of the QSB stock that an investor sold during the taxable year. The potential tax benefits of QSB stock are likely to increase should proposed Biden Administration tax changes be enacted.

In order to qualify as a QSB, the entity must be a domestic C Corporation with aggregate gross assets of $50 million or less at all times before and up through immediately after the issuance of the stock for which the gain exclusion is sought. The shareholder of QSB stock must have acquired the QSB stock at its original issuance in exchange for money or property other than stock or services provided to the issuing corporation. Acquiring stock from an existing shareholder will not satisfy the original issuance requirement. It may, however, be possible for investors to create a new C Corporation to acquire a target business and satisfy the original issuance requirement. In some cases, tax-free reorganizations or restructuring transactions in which QSB stock is exchanged for stock of another company may facilitate rollover of gain exclusion opportunity.

The corporation must also use at least 80 percent of its assets, measured by value, in the active conduct of one or more qualified trades or businesses.

The takeaway here is that QSB benefits can materially alleviate the potentially harsh consequences arising when a business is sold. Such benefits, when combined with the appeal of lower C Corporate tax rates over the prior years of operation, may yield a better scenario for business ownership than would arise under a pass-through structure. We will be happy to provide further details and assist in the evaluation as to whether QSB provisions are a good fit for a particular business opportunity.

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