Maximizing your business’ tax strategies can help you avoid taxes on unrealized gains when done correctly. One benefit many taxpayers miss out on involves excluding a portion of capital gains from qualified small business stock from taxable income.
The Internal Revenue Code provides extensive context for this tax deduction which can lower your income tax liability.
Which Small Businesses Qualify?
There are several circumstances that must be met in order for a C-Corporation to qualify as a small business.
A qualified small business must be a domestic C-Corporation that is not purely an investment company and is not in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, farming, hotel, motel, restaurant, or any trade where the principal asset of the trade is the reputation or skill of its employees. At least 80% of the corporation’s assets must be used for business activities in business excluding those listed above.
The corporation must hold gross assets valued at or below $50 million. This limit must have been applicable to all periods on or after August 10, 1993 (the date of the enactment of the Omnibus Budget Reconciliation Act of 1993). If at any point during that timeframe the value of the gross assets held by the corporation exceeded $50 million then the business does not qualify, even if the value of the gross assets at below the limit today.
If more than 10% of the value of the corporation’s net assets is in stock and securities of other companies then the corporation does not qualify. If more than 10% of the asset value is held within real property that is not actively used for business purposes then the corporation also does not qualify.
What is “Qualified Business Stock?”
In order for a stock to apply under the below tax codes, the stock must be an interest in a qualifying C-Corporation which was issued on or after August 10, 1993. The stock must be acquired at its original issue in exchange for money or other property not including stock or as compensation for services provided to the corporation.
There are a few circumstances that exclude the above stocks from being considered qualified small business stocks:
- If at any point during a four-year period starting two years prior to the issuance of the stock the corporation purchased stock from the taxpayer or anyone related to the taxpayer who holds the stock
- If at any point during a two-year period starting one year before the issuance of the stock the corporation purchased stock with an aggregate value exceeding 5% of the aggregate value of all of its stock as of the beginning of the two-year period
Understanding Section 1202
Once you’ve established that the stock is indeed qualified small business stock, we look to U.S. Code § 1202 for additional guidance. This section of the code provides taxpayers with the right to exclude up to 100% of any gain from the sale or exchange of a qualified business stock held for more than five years. In this instance, “taxpayers” are only individuals – corporations do not qualify.
The percentage of the gain that can be excluded is determined by the date the stock was acquired. Those percentages are:
- 50% for qualified small business stock acquired on or before February 17, 2009
- 75% for qualified small business stock acquired between February 18, 2009, and September 27, 2010
- 100% for qualified small business stock acquired on or after September 28, 2010
Those stocks must be held for at least five years regardless of when the stock was acquired.
Understanding Section 1045
U.S. Code § 1045 adds additional circumstances to avoid or at least defer the gain from qualified small business stock. In this case, the process is more straightforward: if you take the gain realized from selling small business stock and take such gain to invest in another qualified small business stock within 60 days then you can avoid the recognition of the initial gain.
This only applies if the taxpayer held the stock for at least six months and makes a special election for a claim under this section on the federal income tax return for the year of the sale. If the gain realized upon the sale exceeds the cost of any new qualified small business stock minus any portion of the cost already used to shelter gain under this section.
These are nuanced rules under the Internal Revenue Code. If you read all this and are still struggling to grasp how these circumstances may apply to you or your business, you aren’t alone. That’s where The Law Offices of Tyler Q. Dahl come in. Contact us for professional Tax Strategy services.
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