Your business means the world to you. You’ve fostered it from the beginning, working tirelessly to make sure that it has every opportunity for your growth. The reason? To ultimately provide the best life for you and your family after you’ve retired and sold the business. So what happens when you’re ready to sell?
If you're a business owner considering the sale of your company, you're likely focused on maximizing your after-tax profits from the transaction. You may be on the hook for a significant amount of tax from the sale of your business.
What if I told you that there's a little-known tax provision that allows you to exclude $10 million of gain or more when selling your business? Enter Section 1202 of the Internal Revenue Code, a powerful tool that can potentially allow you to pay no tax when you sell your business. Of course, the IRS does not give out candy to everyone; you must meet their criteria.
Section 1202 eliminates up to $10 million of gain per shareholder on the sale of qualified small business stock (QSBS).
While the qualification rules for QSBS are complex, we’ve simplified it for you. Here are the key qualifying criteria:
C-corporation taxation: To be eligible for the Section 1202 exclusion, your business must be taxed as a C corporation from the beginning.
Five-year ownership: You must have owned the business for more than five years.
Original owner: You must be one of the original owners of the company.
Qualified trade or business: The operations of the business cannot be in an excluded activity, which are: many professional activities (accounting, law, medical, etc), consulting, athletics, brokerage services, banking, insurance, financing, leasing, investing, farming, mining, hotels, restaurants and activities where the principal asset of the trade or business is the reputation or skill of one or more of its employees.
Other qualifications: The IRS put up other roadblocks, but they are less common. We will assess these other qualifications when we discuss your particular situation.
If you meet these criteria, the potential tax benefit is significant. You can exclude up to $10 million in gain when you sell your business. If there are multiple owners, each owner can exclude up to $10 million. For a business with three owners, this exclusion could add up to a total of $30 million, which is a substantial sum that can be kept out of the IRS's hands.
No, you must be taxed as a C corp. But no is not the final answer. We have ways to extract a business taxed as a partnership and “drop” that into a new C corp. It takes planning, of which the implementation takes more than five years. Transitioning from partnership taxation to C-corp taxation takes time and a good amount of legal work.
For those who elected to have your business taxed as an S corp, your eligibility comes with a tax cost which may make Section 1202 benefits out of reach. Reorganization may be an option, but it requires careful planning and typically takes up to six years to achieve.
For a business not taxed as C corp, it will require some steps to become eligible for Section 1202. A common approach is to form a single-member LLC subsidiary and use that to form a joint venture with a newly created C corp. This is the beginning of what the IRS calls an “F reorganization”, which is beyond the scope of our discussion. But these steps involve legal intricacies, which can generate tax savings for you that are well worth the effort. Consult your CPA or financial advisor to learn more about those structural changes.
The federal tax rate for C corps is 21%. If the wage you take from your business is sufficient for your lifestyle, then transitioning to C corp taxation is something you should consider. Conversely, pass-through entities like S corps and partnerships are taxed at their owners’ tax rates, which are often (much) higher than 21%.
Pass-through entities like S corps and partnerships are often taxed at a significantly higher rate than C corps. Congress reduced the tax rate on C corps in the 2017 Tax Act. Because this change is still considered “new”, not many entities are taxed as a C corp.
Given the complexity and potential pitfalls of navigating Section 1202 and business taxation changes, we recommended that you seek professional assistance. You’ll need to do your due diligence to find an accounting firm that can help in this way. Very few accounting firms specialize in mergers and acquisitions (M&A) work. The benefits of Section 1202 when you sell your business is considered M&A work. These rules are complex, often involving high stakes. The consequences of getting the reorganization wrong can be severe, with potentially millions of dollars immediately becoming taxable.
In addition, transitioning to a C corp can significantly change the way you take money from your business. It's crucial to consider how this shift will affect your lifestyle. This is, again, where professional guidance can be invaluable. Expert advice can help you make informed decisions about how to optimize your business taxation while minimizing disruptions in lifestyle.
In conclusion, Section 1202 of the Internal Revenue Code is a powerful tool for business owners to save significant money when selling their companies. While it may involve some legal changes, the potential tax savings are substantial if you qualify. If you're in the fortunate position of selling your business, and the proceeds from that sale will be a significant part of your retirement, reach out to a tax professional who specializes in M&A work to see if you qualify for Section 1202. The effort, time, and investment may yield a substantial return in the end.
Remember, the tax code can be your friend, and Section 1202 is a prime example of how it can work to your advantage when selling your business.
What’s next? If you want to know if you are eligible for Section 1202 benefits, please reach out to us. We have extensive experience in helping businesses land this plane. We’re happy to take a no-obligation phone call if you’d like to know more.