Tax Planning Spotlight: Qualified Small Business Stock
By Robert Jacobson, Kutchins, Robbins & Diamond, Ltd. (KRD)
Foreign nationals looking to start a business in the US often find that operating as a C Corporation is most desirable. One of the benefits of becoming a C Corporation is that they can issue Qualified Small Business Stock (QSBC). A QSBC is a US C Corporation that, upon sale, can have a 100% Federal capital gain exclusion for both regular and alternative minimum tax purposes.
US tax law imposes limits on the amount of gain that can be excluded from selling shares in a particular QSBC. In any taxable year, a taxpayer’s eligible gain is limited to the greater of:
- 10 times the taxpayer’s aggregate adjusted basis in the QSBC stock that is sold, or
- USD 10 million.
The QSBC stock must have been held for more than five years to gain the benefit of the capital gain exclusion. State law compliance with Federal law on QSBC stock must be examined on a state-by state-basis.
In order for a C Corporation to be classified as a QSBC, it must meet the following criteria:
- The total assets of the C Corporation cannot exceed USD 50 million.
- 80% or more of the C Corporation’s assets must be used in the active conduct of a qualified business. Qualified businesses do not include services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, brokerage services, or any other business where the principal asset is the reputation or skill of one or more of its employees; banking, insurance, leasing, financing, investing, or similar activities; farming, oil, natural gas, or the operation of a hotel, restaurant, or similar business.
- The taxpayer must have acquired the stock upon original issuance or through gift or inheritance.
- The taxpayer must have acquired the stock in exchange for money, other property (not including stock), or services.
- The corporation must have been a QSBC on the date the stock was issued and during substantially all the period the taxpayer held the stock.
- The acquisition of the stock must have been after 10 August 1993.
Shareholders of QSBC stock also have the ability to defer the gain on a stock sale to the extent they acquire replacement QSBC stock within 60 days of the original sale. They must have held the QSBC stock for more than six months to take advantage of this opportunity. Once the gain is deferred, they must reduce the income tax basis of the replacement stock by the amount of gain deferred. If the replacement stock is QSBC stock when it is sold, the applicable capital gain tax exclusion is available if the more-than-five-year holding period requirement is met.
When a C Corporation internally finances its operations and cannot issue dividends to its shareholders, the 100% capital gain exclusion and deferral tax benefits, combined with the flat 21% corporate tax rate, can make operating a newly formed C Corporation business as a QSBC more tax-effcient than operating it as a Partnership or S Corporation. For example, a newly established business C Corporation is set up as a QSBC. Over the next five years, the QSBC retains all USD 10 million of its taxable income after paying the 21% federal tax rate for C Corporations. For the sake of discussion, the retained income creates a dollar-for-dollar increase in the value of the QSBC stock equal to USD 7.9 million (USD 10 million – USD 2.1 million of tax). The taxpayer eventually sells the QSBC shares for a USD 7.9 million profit and shelters the entire gain with the 100% capital gain exclusion. So, there is no federal income tax on the QSBC stock sale gain. In contrast, the taxpayer operates the same business as a Partnership or S Corporation, and it is taxed at the maximum 37% personal income tax rate. With the new law for qualified businesses, the taxpayer qualifies for the new 20% qualified business income deduction.
Consequently, the effective tax rate on the USD 10 million of taxable income for a Partnership or S Corporation will be 29.6%. [37% x (1–20%) = 29.6%]. Clearly, it is a benefit in this case to operate as a C Corporation taxed at 21%.
Robert JacobsonGGI member firm
Kutchins, Robbins & Diamond, Ltd. (KRD)
Auditing & Accounting Tax, Advisory, Corporate Finance,Fiduciary & Estate Planning
Chicago (IL), USA
T: +1 847 240 1040
KRD Ltd. is a CPA firm that offers a full range of client services: outsourced accounting, audit and assurance, tax strategy and preparation, business valuations, and financial planning advisory services. Their team of 80 members has been serving clients in Chicago, the surrounding areas, and nationwide for over 30 years.
Robert Jacobson, CPA, MST, is a Tax Partner at KRD. He specialises in real estate partnerships, serviceoriented businesses, and high-net-worth individuals. Robert received a BA in Economics and a BS in Accounting from the University of Illinois – Champaign, and a master’s degree in Taxation from DePaul University. Robert is a member of the AICPA and Illinois CPA Society.
Published: International Taxation Newsletter, No. 12, Spring 2020 l Photo: lucky-photo - stock.adobe.com