During the government’s 2020 fiscal year (ending September 30, 2020), there were 1.8 million C corporations and more than 5 million S corporations. While we don’t know how many of them were small corporations, we can estimate that most fit this category because the SBA says that 99.9% of all businesses are “small.”
Win or lose, using a corporation for business start-ups may produce tax breaks for owners. Because of the specific conditions for each break, one or both may apply in a particular situation (i.e., you may use a break if you win or lose). But again, depending on the situation and the outcome of your investment, you may be eligible for one or the other.
If you win
If you invest (or invested after September 27, 2010) in a small corporation, you may be able to have tax-free gains when you ultimately dispose of your holdings. Yes, no tax on your gains, regardless of your income level or anything else. To do so, you must hold Sec. 1202 stock—referred to as qualified small business stock (QSSB)—for more than 5 years and meet some very stringent conditions:
- The stock must be issued by a domestic C corporation. Stock in S corporations can’t qualify for the tax break. And it can’t be a foreign C corporation.
- The business can’t be in certain industries, including performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services; banking, insurance, financing, leasing, or investing; farming; mining; or operating a hotel, motel, or restaurant. What does this leave? Technology, manufacturing, retail, and wholesale businesses are permissible industries for Sec. 1202 stock.
- The stock must be acquired directly from the corporation for cash, property, or as payment for services. The stock can be acquired by gift or inheritance. But it can’t be obtained by buying stock from someone who had acquired the stock in a permissible manner.
- As of the date the stock was issued, the corporation must have total gross assets of $50 million or less. This asset limit applies prior to issuance and immediately after issuance of the stock.
- The corporation can’t be a mere holding company; it must be engaged in a business within a permissible industry. At least 80% of the value of the corporation’s assets were used in the active conduct of one or more qualified businesses (i.e., those that are not in barred industries).
If all these conditions are met, then the gain that’s not taxable cannot be more than the greater of $10 million ($5 million for married persons filing separately), minus any gains excluded in prior years, or 10 times the shareholder’s basis in the stock. Lower limits applied to married persons filing separately.
There’s an added benefit to QSSB stock. Once the gain is 100% excludable from gross income, it’s also exempt from the 3.8% net investment income tax.
Can’t meet the 5-year holding period requirement? There’s an option to defer tax on the gain on QSSB stock held more than 6 months by rolling it over into other QSSB stock within 60 days of a sale.
If you lose
There’s a provision allowing for an ordinary loss with respect to Sec. 1244 stock (defined below) of up to $50,000 ($100,000 for joint filers even if only one spouse owns the stock). This break applies regardless of how long you’ve held the stock. Any loss in excess of the limit is treated as a capital loss, which is deductible to the extent of capital gains for the year, with an excess allowed to offset up to $3,000 of ordinary income. Any losses in excess of the ordinary income limit may be carried forward indefinitely.
To be Sec. 1244 stock, all of the following conditions must be met:
- The corporation must be a domestic corporation (not a foreign corporation). It may be a C or S corporation.
- It must be “small,” meaning the total amount of money and property received by the corporation for the stock may not exceed $1 million. If the corporation subsequently issues more stock and exceeds the $1 million limit, it may designate which shares qualify as Sec. 1244.
- The stock must be issued in exchange for cash and/or property. It can’t be issued as compensation for services.
- Only the owner to whom the stock is issued can use Sec. 1244 treatment. Stock acquired by a gift and an inheritance, or in any other way does not qualify (there are some exceptions for certain corporate reorganizations and stock dividends).
- The stock may be common or preferred stock.
- The corporation must meet a gross receipts test in the year the shareholder has the loss. During the 5 most recent years (or the life of the corporation if less), the corporation must have derived more than 50% of his gross receipts from sources other than royalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities. However, there are no restrictions on the industries for which the stock may be used as there is in the case of QSSB stock.
The loss may be claimed on the sale of the stock or if it becomes worthless. You don’t have to attach anything special to the tax return, but be prepared to prove the validity of Sec. 1244 stock if the return is questioned by the IRS.
Final thoughts
There are several points to keep in mind:
- These tax breaks don’t apply to interests in limited liability companies, partnerships, or sole proprietorships. If you’re thinking of starting a business and considering which type of entity to use, these tax breaks on factors to keep in mind. They certainly are not the only factors for entity selection, but they shouldn’t be ignored.
- Pending legislation has not suggested that any changes be made to these tax breaks.
- The rules are complicated, so work with your CPA or other tax adviser to see how they fit into your situation.
