BY CARL GRASSI
Published in Crain's Cleveland Business
September 8, 2013
While the result of the American Taxpayer Relief Act of 2012 for many business owners was an increase in tax rates, one provision that has largely been overlooked is the extension of the elimination of capital gains tax on sales of certain corporate stock.
The act not only extended this benefit through the end of 2013, but retroactively made it effective for all of 2012.
Under this provision, individual taxpayers can exclude 100% of the gain realized on the sale of qualified small business stock (QSB stock) that was acquired after Sept. 27, 2010, and before Jan. 1, 2014, and held for more than five years.
No alternative minimum tax preference will be applicable to gain on the sale of QSB stock, nor will the gain be subject to the 3.8% Medicare tax on investment income of higher income taxpayers. The sale of qualifying QSB stock will therefore be totally tax-free.
This extension provides several opportunities for companies adopting or utilizing already adopted stock incentive plans for their employees.
QSB stock includes stock issued to employees as compensation for services provided to the corporation. The five-year holding period requirement would provide a built-in incentive for employees to stay with the company for that period of time to enjoy a complete elimination of taxes on the eventual sale.
The ability to sell the stock in the future and pay no taxes would certainly be seen as an added benefit by the recipient employee.
Employees who previously received stock options may want to consider exercising those options in 2013 to take advantage of this exclusion.
Because the exercise of an option usually results in compensation income to the employee/option holder, most employees do not exercise their options until an event (such as the sale of the company) happens that will provide cash proceeds to pay the tax.
Given the opportunity to pay no tax on the eventual sale of the stock, an exercise of an employee-held option may be worth looking into, even if it requires an investment of the exercise price and recognizing current compensation income. In order for stock to qualify as QSB stock, it must meet the following basic requirements:
n It must be stock acquired as an original issuance from the corporation. While warrants and options do not qualify as QSB stock, if this type of instrument is exercised to acquire QSB stock, the exercise will be a qualifying acquisition (for example, original issuance). The QSB stock must be acquired for money, property (other than corporate stock) or services provided to the issuing corporation.
n The corporation issuing the stock must be a qualified small business. In general, a qualified small business is a C corporation with aggregate gross assets of less than $50 million at any time before (or immediately after, taking into account any monies invested by the stockholder) the issuance of the stock. The fact that the corporation's assets increase and become worth more than this limit after the issuance is not relevant.
n The corporation must also meet an active business requirement, meaning the corporation uses at least 80% of its assets, measured by value, in the active conduct of one or more qualified trades or businesses. Services-type businesses generally will not qualify.
There are a number of more detailed requirements that must be considered. There also is a limitation on the amount of the gain that can be excluded equal to the greater of: 10 times the taxpayer's basis in the corporation's QSB stock disposed of by the taxpayer in the tax year, or $10 million.
Because C corporations are not tax efficient in many circumstances, a business owner starting a new business should carefully consider the potential tax drawbacks of operating as a C corporation.
For a business already operating as a C corporation, offering shares to employees or to investors will, through the end of this year, have the potential added bonus of providing tax-free income in the event of a sale of such stock to a third-party buyer.
This can be a very tax efficient strategy for investors, business owners and employees. But the stock must be issued this year and must meet all of the requirements. Consult with a corporate tax professional to see if this strategy might provide tax benefits for your business.
Carl Grassi is the president of McDonald Hopkins LLC.