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Section 1202 Qualified Small Business Stock Pitfalls

I wrote a post a few weeks ago about all of the great benefits of Section 1202 Qualified Small Business Stock (QSBS).   But frankly? It would be irresponsible of me not to follow up and point out some qualified small business stock pitfalls.

Accordingly, in this post, I discuss the four big ways the Section 1202 “qualified small business stock” exclusion can blow up and cause taxpayers problems.

Double Taxation of C Corporations

A first potential problem? C corporations, or “C corps,” burden business owners with two layers of tax: one layer at the corporate level and another layer at the owner level if or when profits are distributed.

This double layer of taxation is the reason pass-through entities are generally more advantageous for small business owners.  Not only do pass-through owners enjoy a single layer of tax, but beginning in 2018 they get a Qualified Business Income Deduction (QBID), allowing them to avoid income taxes on 20% of their business income (with some caveats).

Let’s look at a couple examples.

Example 1: A C corporation owner earns net income equal to $100,000 and wants to distribute all $100,000 of the profits.  The C Corp pays $21,000 in tax at the entity level (because of the 21% C corporation tax rate). That leaves $79,000 to distribute.  The owner will then pay another $15,800 in taxes on the qualified dividends (because the $79,000 gets subjected to a 20% dividend tax rate) and then possibly also $3,000 in net investment income taxes (because the $79,000 also gets subjected possibly to a 3.8% net investment income tax.)  In the end, the taxes total about $40,000 and the net payout equals roughly $60,000.

Example 2: An S corporation owner also earns net income equal to $100,000 and also wants to distribute all $100,000 of the profits.  Assume she or he pays a personal tax rate of 30%.  The shareholder takes an immediate $20,000 Section 199A “QBID” deduction (calculated as $100,000 times the 20% QBID rate) leaving $80k of taxable income.  Using the 30% tax rate, the shareholder pays $24,000 of tax and therefore enjoys a net payout equal to $76,000.

That’s a $16,000 difference in taxes paid, or as much as a 16% higher combined tax rate with the C corporation.

How much in capital gains would you need to exclude using QSBS to justify paying more in taxes as a C Corp for some number of years?  Obviously, this will take some financial analysis and modeling to figure out. But you want to consider this issue.

Asset vs Stock Sales

A second issue to ponder…

Typically, businesses get sold by either selling stock or selling assets.  But buyers may prefer asset sales.  Why? The buyer of business assets probably gets to allocate the purchase price to those assets, and then usually gets to deduct that cost over time in the form of depreciation or amortization.

Example 3: The assets of an existing firm include $15,000,000 of goodwill. A corporation can either buy the existing firm’s stock or its assets. If the buyer purchases the assets, the buyer adds a $1,000,000 “goodwill amortization” deduction to its tax return for 15 years. That large additional annual tax deduction saves the buyer millions in income taxes.

So what does this mean? A buyer should be willing to pay a higher price for business assets than business stock.  If the additional bump in price is greater than the money saved on the Section 1202 gain exclusion, you are probably better off staying a pass-through.

Untimely Stock Sales

A third thing to consider: You must hold your QSBS stock for at least  5 years to exclude capital gains, so let’s play the “what if” scenarios.  A situation forces you to sell your stock early and you have a large taxable gain; all the while running your company as a C Corp and forgoing the advantages of a pass-through.  This is bad. On the flip side, you might end up selling at a loss and again forgo years of benefits operating as a pass-through.  This is also bad.

Appreciated Assets at Incorporation

A fourth subtle thing to consider if an existing business incorporates to create qualified small business stock: net investment income tax on any “built in” gains on contributed assets.

Why? That “built in” gain can’t be sheltered by Section 1202. As I.R.C. § 1202(i)(1) states, “the basis of such stock in the hands of the taxpayer shall in no event be less than the fair market value of the property exchanged.”

Predictably, then, if  the business later sells its stock, that the “built in” gain or appreciation gets subjected to capital gains tax. And then, because of the incorporation, the “built in” gain also gets subjected net investment income tax.

Incorporation, then, essentially triggers the net investment income tax on the “built in” gain that Section 1202 doesn’t shelter.

Example 4: A single member LLC operating as a disregarded entity owns $10,000,000 of inventory and $10,000,000 of “goodwill.” The inventory originally cost $10,000,000. The entrepreneur didn’t, however, pay anything for the goodwill. She or he created that value through hard work. If the LLC sells its assets, the LLC member probably pays a 20% capital gains tax on the $10,000,000 of goodwill, or $2,000,000. However, if the LLC incorporates, the $10,000,000 of goodwill may be taxed at 23.8% (a combination of the 20% capital gain tax plus the 3.8% net investment income tax) for a total of $2,380,000.

Final Thoughts Section 1202 Qualified Small Business Stock Pitfalls

The Section 1202 exclusion on qualified small business stock seems very attractive at first glance.  Start doing some financial modeling, however, and it is easy to see the some qualified small business stock pitfalls.

I would encourage anyone considering this to first meet with their tax adviser and see if they can make the numbers work.




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