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24 July 2018

Beware of This Small Business Corp Tax Advice

Beware of This Small Business Corp Tax Advice

Tax code changes have led to a wealth of advice for small business owners hoping to take full advantage. But one-size-fits-all advice rarely works. One such piece of advice is directed at qualified small business corporations (QSBC), claiming tax-free gains on shares that are sold (such as when the owner exits the business). A few important stipulations are often overlooked, though.

Articles like this one from EHTC.com tout tax advantages that come with QSBC stock acquired between August 10, 1993, and September 28, 2010. The article claims the sale of such stock is potentially eligible for a 100% federal income tax exclusion, translating into a 0% federal income tax rate on the profits. This point, however, is short-sighted for exiting business owners. Here’s why:

  1. It’s not easy to qualify for the exclusion. Only stock in domestic C-Corporations qualify, but the C-Corp can’t be a hotel, restaurant, financial institution, real estate company, farm, mining company, or business relating to law, engineering, or architecture. The shares must be held for at least five years before selling and meet these additional conditions set by the IRS, as well.

  2. In our experience, nearly all small business owners sell assets instead of stock when they exit, turning this “amazing” tax advantage into a moot point. This guide by mergers and acquisitions advisory firm Transact Capital explains why. Basically, while both a stock sale and an asset sale can accomplish the goal of passing ownership of a company, a buyer may inherit additional risk with a stock sale. As Transact Capital explains risks for past events, such as underreporting taxes or a sexual harassment lawsuit can pass to the buyer in a stock sale, which don’t transfer in an asset sale.

3.     Attempting to qualify as a QSBC could be expensive for a business owner in the long run, especially if the C-Corp retains losses. When this happens, the owner will still pay taxes on his or her salary while the C-Corp can build up the losses for future use. This can cause major income tax challenges for the individual business owner. We’ve seen business owners incur corporate losses greater than their salaries (which were still taxed). When such losses are likely, a flow-through entity like an LLC or S-Corp may be more beneficial for the business owner. This is one of many reasons why owners should consider possibly changing their business structure at least five years before exiting the business.

If you’re already a QSBC planning an exit, don’t be distracted by “canned” advice promising tax-free gains. Feel free to talk to us about whether selling stock or assets will be right for you.

Image Copyright: wasja / 123RF Stock Photo

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