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Incorporate Now to Leverage 100-percent Capital Gain Exclusion

By Marcia Richards Suelzer, MA, JD | February 14, 2013

Incorporating your business now may yield a surprising result when you sell it in the future: You won't have to pay tax on gain from the sale!

Tucked deep in the recesses of the Internal Revenue Code is a provision designed to spur business growth by providing a tax break for those who invest in small business stock. An individual can exclude 100 percent of the gain realized from the sale of certain small business stock. Yes, all the gain can be tax free.

Example

You invest $1,000 in Big-Multinational-Corporation (BMC). Five years later you sell your stock for $101,000, which is a gain of $100,000. Assuming a long-term capital gains tax rate of 20 percent, you will owe $20,000 in tax on the sale. 

However, if you purchase $1,000 worth of shares in Mom-n-Pop, Inc. (a very small business), and you sell the stock for $101,000 in five years, you will not owe any tax on the gain from the sale of the shares. You can pocket the $20,000 instead of paying it to Uncle Sam.

This ability to exclude gain from the sale of qualified small business stock creates an extraordinary opportunity for you to incorporate your business, hold onto the stock for the required period of time and then sell the stock without paying any tax on the gain you realize. What's more, although you must acquire the stock when it is originally issued, your tax break is preserved if the stock is transferred by gift or upon your death. Plus, your holding period carries over to the transferee.

When Does Incorporating Make Sense?

While there are many tax and non-tax ramifications to consider before incorporating your business to take advantage of the exclusion of gain upon the sale of the stock, here are some circumstances when it merits serious investigation:

  • Your business is thriving and you see great growth potential. This is a great way to ensure the appreciation in value is tax free when you exit the business.
  • You want to make it easy to transfer your business to your children or other family members. The exclusion from income applies to gifts of stock.
  • You have key employees that you want to compensate. By making them shareholders you can foster the relationship while providing them with an opportunity for tax-free income.
  • You see a growth opportunity and you want to attract investors. Being able to promise tax-free gain is a great incentive to offer potential investors, especially those that might be subject to the 3.8 percent Medicare tax on net investment income. Tax-exempt income is excluded when determining net investment income for purposes of this tax.

If any of these apply to you, it's time to talk over your options with a business adviser.

Act Now

Beginning in 2014, the 100 percent exclusion will drop back to a 50 percent exclusion of gain.

What Stock Qualifies?

This is tax law, so (of course) there are conditions that must be met in order to take advantage of the exclusion. The good news is that most small businesses will have no trouble meeting them. The major requirements are as follows:

  • Type of business. The business:
    • must be a regular C corporation;
    • must have $50 million or less in capital;
    • must use 80 percent of the value of the corporate assets in the active conduct of business; and
    • must not be a personal services business, banking or finance business, leasing business, hospitality business, farming or mining business
  • Acquisition of stock. The individual must acquire the stock:
    • before January 1, 2014;
    • at its original issue; and
    • using money or contributed property (not other stock) or as compensation for services to the corporation.
  • Holding Period. You must hold the stock for more than five years from the date of acquisition. (But, the original owner's holding period is tacked onto the holding period for those who receive stock by gift or inheritance.

As you can see, with planning, most small business owners will be able to meet these conditions.

Annual limitation on amount of gain excluded. While the exclusion on gain is generous, it is not unlimited for any given year. For each tax year, you are able to exclude the greater of 10 times your adjusted basis in the stock or $10 million (reduced by any amounts previously excluded). However, dispositions of stock can be structured to maximize the exclusion.

What about 'Double Taxation' on C Corps

The fact that the corporation must be a regular (C) corporation and not an S corporation raises the bogey-man of  'double taxation' in the minds of many small business owners.  However, recent changes in the tax law have rendered this bogey-man far less frightening that it may have been in the past.  For example, the top individual tax rate (39.6 percent) is now significantly higher than the top corporate tax rate (35 percent).  Plus, there is now a phase out of personal exemptions and itemized deductions at higher income levels, meaning more of your income will be subject to tax.  

What's more, operating as a corporation enables you to structure your compensation as part salary and part dividend.  This means that you will only pay self employment taxes on the salary portion.  Another plus is that the tax rate on the dividend portion (assuming that it is a 'qualified dividend') is capped at 20 percent—which is likely to be far lower than your tax bracket for ordinary income.  And, dividends paid from a trade or business in which you were an active participate are not included when determining the 3.8 percent tax on net investment income.

While both a C and an S corporation can structure compensation as a combination of salary and dividends, a C corporation offers the opportunity to hold income within the corporation, provided the accumulation is reasonable. Income that is not paid out will not be taxed twice.  

As you can see, even with conditions and limitations, the opportunity to get tax free gain from your business is a planning opportunity that does not happen often. And, it is one definitely worth your time to investigate.

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