Small business owners often shun C Corporation status because of its various tax drawbacks, perhaps most significantly, the dreaded double tax. However, in recent years, Congress has enacted tax provisions designed to incentivize new investment in small C Corporations. Specifically, Congress has expanded the benefits of Section 1202, which now affords taxpayers significant potential tax savings when realizing gains upon the sale of their small business stock. There are several limitations (discussed below), but this provision offers an excellent opportunity for taxpayers who are thinking about converting their partnerships and certain LLCs to C Corporations, or who are considering starting a new business in the coming months. To qualify for this beneficial tax treatment, taxpayers must obtain their C Corporation stock before January 1, 2014, so time is of the essence.
How does it work?
Taxpayers who during September 27, 2010 to December 31, 2013 acquired “original issue” stock in qualified small businesses are permitted by Section 1202 of the Internal Revenue Code to exclude from income the full amount of any gains realized upon the ultimate sale of that stock, provided that the taxpayer holds the stock for at least five years before selling it and that certain other requirements are met. Additionally, any gains that are realized upon the sale of stock will not be subject to the Alternative Minimum Tax (AMT).
Illustration: Dave has decided to start a company to develop a new smartphone application. On November 1, 2013, Dave forms a C Corporation and receives 100 shares of the corporation’s stock in exchange for an investment of $10,000, which will cover initial operating costs. Over the next five years, Dave’s application becomes wildly popular, and eventually a major social networking website offers to purchase Dave’s application. On November 2, 2018, Dave sells all of the stock in his C Corporation to the social networking website for $5,000,000 and realizes a gain of $4,990,000. Because Dave received his original issue stock in the C Corporation during 2013, he will not be required to pay any capital gains or alternative minimum tax related to the sale of the company.