It is customary for business founders to select a limited liability company or an S corporation as the entity for their start-ups.  The allure is straightforward    neither entity is taxable, and the income of the business is taxed only to its owners.

Increasingly, however, founders are considering C corporations, even though the income of such corporations is taxed both to the corporation and, upon distribution as dividends, to the shareholders.  The attraction of the C corporation is the opportunity to exclude from income tax a substantial portion of the capital gain when the corporate stock is sold.

This opportunity is created under section 1202 of the Internal Revenue Code, which allows shareholders to exclude a minimum of $10,000,000 of capital gain upon the sale of “qualified small business stock.”

The section imposes numerous requirements for “qualified small business stock,” but here are the principal ones:

1.  The stock must be acquired from a C corporation and sold while the corporation is a C corporation.

2.  The stock must be acquired directly from the corporation for cash, property, or services.  The stock may be voting or non-voting common stock or preferred stock.  It may not, however, be non-vested stock that is subject to a substantial risk of forfeiture, stock options or warrants.

3.  The stock must be held for more than five years.

4.  The stock itself must be sold in order to get the benefit of the capital gain exclusion.  As the founder considers potential exit strategies, the founder will have to be mindful that an asset sale will not produce the capital gain exclusion under section 1202.

5.  The corporation may not have aggregate gross assets in excess of $50,000,000 at any time before or immediately after the issuance of the stock.

6.  At least 80% of the corporation’s assets (by value) must be used in activities that are “qualified trade or business” activities.  Importantly, such activities exclude services in the fields of health, law, engineering, architecture, accounting, consulting, financial services, brokerage services, financing, investing, and any business where its principal asset is the reputation or skill of one or more of its employees.

 7.  No more than 10% of the total value of the corporation’s assets may consist of real property that is not used in the active conduct of the corporation’s trade or business.  Renting or dealing in real estate is not considered to be conducting an active business activity.

If the stock meets the requirements for “qualified small business stock,” upon sale, the shareholder may exclude from capital gain the greater of $10,000,000 or ten times the value of the cash and property that the shareholder contributed in exchange for the stock. 

With proper planning, a shareholder may multiply the tax exclusion as part of his or her family wealth planning.  For example, if a shareholder transfers a portion of “qualified small business stock” as a gift to a family member, the recipient will hold the stock with the donor’s tax basis and holding period and will get a separate full capital gain exclusion upon the sale of the stock.  Similarly, stock may be transferred to a trust for one or more family members.  If the trust is not a grantor trust (in which the transferring shareholder is treated as the owner of the trust for income tax purposes), it too will hold the stock with the donor’s tax basis and holding period and will get a separate full capital gain exclusion upon the sale of the stock.  In each case, the donor shareholder will get a full capital gain exclusion for any stock retained, and the recipient individual or trust will get a separate full capital gain exclusion.

There are many nuances and complexities in business planning for the eligibility of “qualified small business stock” and estate planning to obtain the optimal tax benefit for family members and future generations.  For business founders, this planning is best addressed at the outset of the start-up.  For more information, please contact Robert L. Teicher or another BW attorney.

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