Additional Benefits Of Section 1202
Moreover, Section 1202 of the Internal Revenue Code provides further benefits to individual shareholders in C corps.
Section 1202 exempts individual investors from tax on the gain from the sale of “qualified small business stock.” The gain exemption is limited to the greater of (a) $10 million or (b) 10 times the investor’s stock basis.
This Tax Code section has several technical requirements.
• First, the investor must hold stock in a C corp for more than five years to qualify.
• Second, at the time of the stock’s issuance and immediately after, the corporation must have assets with an adjusted basis of not more than $50 million (and usually a fair market value also equal to $50 million).
• In addition, the corporation must be engaged in the active conduct of a qualified trade or business (which generally excludes professional service businesses, banking and insurance businesses, farming, oil and gas producers, and hotel and restaurant operators).
In the above example, if Devon were to hold onto the stock in her medical device company for at least five years and subsequently sell the stock at a profit, a gain of up to $150 million would be tax-free to her.
Minimizing Administrative Burdens
Structuring a business as a C corp also minimizes the administrative burden imposed on taxpayers who own interests in pass-through entities and often must file tax returns in multiple states as a result of the businesses’ operations in different states. A shareholder in a C corp, by contrast, does not have to make tax filings in states where the corporation operates.
When a member of an LLC sells his or her interest in the company, it is also possible for different states to tax the sale differently (either as tangible or intangible property) in a way that might subject the LLC interest holder effectively to double tax. A shareholder’s sale of stock is generally sourced to the stockholder’s residence and therefore is not subject to additional tax in the state where the corporation does business.
Taxpayers therefore will find it easier to operate as a C corp: only the corporation must file federal and state tax returns for its business operations.
The example above shows it is time for business owners to revisit the structuring of their business operations. If you own an interest in an LLC or S corp, work with your advisors to evaluate the costs and benefits of converting the entity to a C corp.
Rudyard Kipling once advised “keep your head when all about you are losing theirs.” Such advice is sound in these times of uncertainty. Run the numbers and take calculated risks. In this way, you can engage in effective business planning for the future.
Sandra O’Neill is a tax attorney at the Massachusetts law firm of Bowditch & Dewey. She advises clients on federal income tax matters in corporate mergers, acquisitions, joint ventures and planning initiatives including the structuring of cross-border and intellectual property buy-in transactions. She also assists clients with partnership and REIT tax issues in the formation of real estate investment funds.