There are many considerations when choosing an entity type for your business. If your intentions are for long-term tax benefits consideration should be given to one of the more traditional forms of business entity – the C Corporation.

One of the first corporate statutes was enacted in New York in 1811, so C Corporations have existed for some time. Since that time other forms of business entities have been established. Due to the double taxation of income (tax on corporate profits and tax on the dividends paid to the shareholders), flow-through entities such as the S-Corporation (a C Corporation that makes a tax election to “pass-through” profits to be taxed at the shareholder level), partnerships, and LLCs came into favor.

However, in 1993, the Internal Revenue Code was updated with Section 1202 establishing the Qualified Small Business Stock (QSBS) Exclusion which was an attempt to motivate investors to fund small business formation by allowing individuals to avoid paying taxes on 50% of any taxable gain realized from the sale of “qualifying” small business stock.

Since 1993, the maximum gain exclusion under Section 1202 has been expanded from 50% to 100% for the sale of Qualified Small Business Stock.  Depending on when the stock in the corporation was acquired, Section 1202 allows the selling shareholders to exclude from gross income 50% to 100% of the gain from the sale of QSBS that is held for more than five years. As with any tax benefit available, specific requirements must be met by both the shareholder and the corporation.

For the Shareholder:

• The shareholder must own the stock either directly or through a pass-through entity.
• The QSBS must be held by the shareholder for more than five years before it is sold.
• The shareholder must have acquired the stock when originally issued on or after August 10, 1993.

For the Corporation:

• Recalling the original intent of IRC Section 1202, the Corporation must be a qualified small business. A QSB cannot have assets in excess of $50 million from August 10, 1993, to immediately after the issuance of the stock.
• The business must meet the definition of an active business, meaning that at least 80% of the company’s assets are used in a qualifying trade or business. A qualified trade or business does not involve services in the field of health, law, engineering, architecture, accounting, sciences, consulting, or financial services including brokerage services.

Any potential for gain exclusion from the sale of QSBS can be monumental to shareholders when making the decision to sell their interest. However, it is imperative to meet all the requirements at both the shareholder and entity levels to succeed. Planning for this can create opportunities for your business.

Article Written by Tom Valentino, CPA

For questions or further assistance regarding this topic, please contact Tom at tom@innovativecpagroup.com or call 203-489-0127.