The Small Business Jobs Act of 2010, enacted on September 27, 2010, excludes 100% of the gain on the sale of qualified small business stock held by noncorporate taxpayers for more than five years. Prior to February 2009, Internal Revenue Code Section 1202(a) provided that 50% of a noncorporate taxpayer’s gain on the sale of qualified small business stock (held for more than five years) would be excluded from gross income. The American Recovery and Reinvestment Act of 2009, also known as the “stimulus act,” increased the exclusion to 75% (for stock purchased from February 17, 2009 until January 1, 2011) in order to encourage investment in small businesses.
Under the new law, the percentage of gain excluded is increased to 100% for qualified small business stock acquired after September 27, 2010 and before January 1, 2011. In addition, none of the excluded gain on such stock will be considered an alternative minimum tax (AMT) preference. Thus, no federal income tax or AMT will be imposed on a gain from the sale or exchange of qualified small business stock acquired between September 27, 2010 and January 1, 2011 and held for more than five years. In addition to federal income tax benefits, the amount of gain would also escape taxation by states that base their taxation on federal taxable income. The 3.8% Medicare tax on unearned income enacted as part of the Patient Protection and Affordable Act set to take effect in 2013 would also be avoided.
Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C corporation (S corporations aren’t eligible) in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50 million. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements.
Certain C corporations are ineligible for the benefits of this new law, including;
- Professional Service Businesses
- Real Estate Companies
- Financial Service Businesses
- Hotels and Motels
- Mining and Mineral Extraction Companies
Converting Pass-Through Entities to Take Advantage of the New Rules
Partnerships and LLC’s that would otherwise be eligible to take advantage of the tax benefits under the new law if they operated as a C corporation may want to consider converting to a C corporation before January 1, 2011. Taxpayers should beware however, that there are several considerations that must be taken into account before reorganizing as a C corporation. For example, the exclusion on the gain from the sale of qualified small business stock does not include the built-in gain at the time of the reorganization. Any appreciation of the taxpayer’s ownership interest before converting to a C corporation will be immediately taxable when the stock is sold in the future. Therefore, taxpayers who hold ownership interests in partnerships and LLC’s that have substantially appreciated but aren’t projected to appreciate greatly over the next 5 years may not benefit much from the new law.
Taxpayers considering converting to a C corporation must also keep in mind that earnings and profits will be subject to taxation at the corporate level rather than being passed through and taxed at individual rates. Also, any dividends distributed out to stockholders will be subject to double taxation. With the current uncertainty concerning the 2011 tax rates, this could substantially affect the taxpayer.
There are many factors to take into account before converting to a C corporation, and the window of opportunity to take advantage of this new tax provision is rapidly closing. However, a partnership or LLC that is expecting substantial appreciation in the next few years may benefit greatly from making the conversion to a C corporation by January 1. Essentially, the new 100% exclusion of gain on the sale of qualified small business stock removes the primary disadvantage of conducting business as a C corporation, that of double taxation.
If you would like further information on whether your organization can benefit, please contact Marty DiGiovine at firstname.lastname@example.org.
Schneider Downs provides accounting, tax, wealth management, technology and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.