With an increased capital gain tax rate of 20 percent for tax years 2013 and after, small-business owners should be aware of a provision that eliminates one-half or more of capital gains recognized on the sale of their C corporation stock.
Enacted in the early ’90s, Internal Revenue Code Section 1202 excludes 50 percent of the corporate stock gain, provided that the stock has been held for more than five years before the sale. This provision applies to original issue stock issued to noncorporate stockholders after August 10, 1993.
The total assets of the issuing corporation must not exceed $50 million on the date of issue and sale.
For stock issued after Feb 17, 2009, and before Sept. 28, 2010, the exclusion is 75 percent of qualified small-business gain. The exclusion is 100 percent for stock issued after Sept. 27, 2010, and before Jan. 1, 2014.
Corporation stock issued in an empowerment zone after Dec. 21, 2000, has an exclusion rate of 60 percent for empowerment zone stock sold before Jan. 1, 2019. Empowerment zones are certain geographic areas with enhanced tax benefits that terminated after Dec. 31, 2013.
How does this provision affect an existing business?
Does your company need capital?
Instead of lending the corporation money, the business owner may issue new stock. If the stock is issued more than five years before the business is sold, one-half of the gain from this newly issued stock is tax-free.
If the company grants stock options to employees, it should consider funding the executed stock option with new small-business corporation stock. Not only does the employee receive an equity position, but if the company performs favorably in the future, the employee’s sale of stock is 50 percent or more tax-free.
A company may convert its debt to stock and give the newly issued stock to the former debt holder. If the debt holder sells the small-business stock more than five years later, the gain is only 50 percent taxable.
Small-business stock converted to preferred stock is treated as qualified small-business stock. Some employers may pay bonuses with original issue stock, which saves the company’s cash and potentially reduces the capital gains tax that the employee may pay when the company is sold.
Some wealthy employees may choose to make charitable contributions with their fully taxable stock and keep qualified small-business stock to sell if the company is seeking a future buyer.
The gain exclusion also reduces the net investment income tax of 3.8 percent on excluded gains. Net investment income is gross income from interest, dividends, annuities, royalties, rents and substitute interest and dividend payments, but not to the extent this income is derived from a trade or business. Net gains are net investment income if recognized as attributable to property disposition, but not to the extent the property is held by a trade or business.
The net investment income tax applies to:
- Single taxpayers if their adjusted gross income is over $200,000
- Married taxpayers if their adjusted gross income is over $250,000
- Married taxpayers filing separately if their adjusted gross income is over $125,000
The tax is computed by taking 3.8 percent of the lesser of:
- Taxpayer net investment income for the tax year, or
- Adjusted gross income in excess of the threshold amounts of $200,000 (single taxpayer), $250,000 (married taxpayer) or $125,000 (married filing separately).
One CPA client’s 2013 business stock sale saved over $485,000 in income and net investment taxes. This savings resulted because, during the past decade, the client’s corporation issued original stock to its employees after they had executed their stock options.
Can a sale of stock result in zero tax on qualified business stock gain? Yes, paying no tax is achievable.
A noncorporate stockholder is allowed under IRC Section 1045 to exclude capital gain from the sale of qualified business stock if it has been held more than six months – and if similar small-business stock is acquired within a 60-day period beginning on the date of the stock sale. Gain is recognized only to the extent that equal dollars are not reinvested in qualified small-business stock within 60 days of the previous stock sale.