Congress just gave some small business owners looking to retire soon a huge gift! In December of 2015, a previous extension of IRS Code s. 1202 of the Protecting Americans from Tax Hikes Act of 2015, or PATH Act, was made permanent. Under this provision, small business owners and investors can exclude 100% of any gain they realize from the sale of qualified small business stock.
In the past, taxation varied from partial taxation of gain to full exemption from tax. Planning was difficult however because the amount of the exclusion changed and planning was too difficult.
In order to benefit from this exemption, the stock must meet certain requirements, such as:
- The stock must be directly secured as an original issuance from a C corporation;
- The company must have $50 million or less in capital;
- 80% of the value of the corporate assets must be used in the active conduct of the business or trade;
- The stock must be held for at least five years;
- The stock must be active in eligible sectors. Excluded business types include personal services, law, banking, finance, leasing, hospitality, health, farming or mining.
IT’S NOT WHAT YOU MAKE, IT’S WHAT YOU KEEP
Why is this significant to business owners? Business owners often have a significant portion of their assets in their business. When they want to sell their business to fund their retirement, they need to calculate the final amount they will receive from the sale, after repaying any debt, ongoing expenses, brokerage fees, and taxes. If tax on the gain in a given circumstance would have been perhaps 20% in the past, and with this new exemption, there is no tax due upon sale, this is a significant added amount of money a business owner can yield from the sale. These additional hundreds of thousands of dollars, or millions of dollars, can make the difference between an owner feeling that a deal is acceptable or just not enough to make it worthwhile. The added tax forces an owner to require a higher sales price to meet his needs than if there is no tax being deducted on the sale.
This will be significant also going forward for new start up businesses. In the past, C corporations were avoided in many circumstances due to the spectre of higher taxation, more complicated legal requirements. Business owners and their advisors, including their investment advisors, accountants and lawyers, will play a critical role in advising businesses on which entity to choose and whether it makes sense to choose a C corporation to take advantage of this new permanent tax break.
article by Anne Ertel-Sawasky