The PATH ACT – Permanently Extending the Qualified Small Business Stock (QSBS) 100% Gain on Sale Exclusion
Many small business owners face a large tax liability in the year of selling their business. A typical business owner will work in the business for many years, dutifully paying all applicable taxes. Then, when cashing out to retire, the federal government (and maybe the state where the business resides) wants one last, large, piece of the pie. Depending on the type of business being sold and the structure of the purchase and sale agreement, it’s entirely possible for a business owner to pay over half of the sales price to the IRS and state tax authorities.
Key to taxation results is whether the sale is structured as a stock or asset transaction. In addition, the legal and tax structure of the company being sold (partnership, s-corporation, or c-corporation) makes a tremendous difference for tax results.
There have been relatively few federal tax law changes over the past several years with regards to these types of domestic sale transactions. However, recent legislation passed by Congress has significantly changed the tax calculus for sales for small businesses operating as “C” corporations, if the sale transaction can be structured as a stock sale instead of as an asset sale.
In December 2015, the Protecting Americans from Tax Hikes (“PATH”) Act was passed into law. The PATH ACT made permanent the 100% exclusion of gain on sales of stock that qualify under the Section 1202 rules of the Internal Revenue Code. Section 1202 allows a taxpayer to exclude up to 100% of the gain from the sale of Qualified Small Business Stock (“QSBS”).
In order for stock to qualify stock as QSBS, several requirements must be met, including: (1) the stock must have been initially acquired from the company for valuable consideration by the shareholder, (2) the stock must be issued by a domestic C-corporation, (3) the C-corporation must have gross assets not exceeding fifty million at the time of the stock issuance and beforehand, (4) the corporation must operate an active trade or business, and (5) the shareholder must have held the QSBS for at least five years.
If the stock qualifies as QSBS, then a certain percentage of the gain from the sale is excludable under Section 1202. The excluded percentage depends on the date the QSBS was issued to the taxpayer. Any QSBS received between 1993 and February 18, 2009 is eligible for 50% gain exclusion. Any QSBS acquired between February 18, 2009 and September 27, 2010 is eligible for 75% gain exclusion. Any QSBS acquired after September 27, 2010 is eligible for 100% gain exclusion. Prior to the enactment of the PATH Act, the 100% exclusion had to be extended by congress on a yearly basis. Because QSBS must be held for five years to qualify, any planning involving QSBS was tenuous. However, the PATH Act permanently extended the 100% exclusion on eligible gain for sales of QSBS.
While there are some limits to the QSBS exclusion (for instance, there is a ten million maximum exclusion per issuer per shareholder and a maximum exclusion of ten times the shareholder’s basis in the stock), overall QSBS is a powerful tool to eliminate or reduce tax liability stemming from the sale of a C-Corporation. We are only now starting to see the full benefits of the 100% QSBS exclusion. Due to the five year holding period, September 27, 2015 is the earliest date any transaction could theoretically qualify for a 100% QSBS exclusion (rather than 50% or 75% exclusion). As more taxpayers and advisors see the benefits of QSBS, the gain exclusions available upon sales of QSBS make it likely that more business entities will form as C-Corporations, in particular those businesses that have a set mid-term exit plan and large initial capital investments. Overall, QSBS can significantly reduce the tax for some small business sales. Therefore, whether forming, operating, or selling a small business, taxpayers should consider the potential tax benefits of QSBS.
The information provided herein is general in nature and not specific legal advice. The information should not be relied upon for any purposes.