A $10 Million Tax Benefit for Small Business Investments

by Andy Strauss The Tax Cuts and Jobs Act of 2018 (“TCJA”) reduced corporate and personal income tax rates (top personal rate fell from 39.6% to 37% and the top corporate rates are now a flat 21%), but also eliminated many deductions. Notable deductions that were eliminated include moving expenses and alimony. It also eliminated deductions for unreimbursed employee expenses, tax preparation fees, and other miscellaneous deductions. Theft and personal casualty losses cannot be deducted, although taxpayers can still claim a deduction for certain casualty losses occurring in federally declared disaster areas. TCJA also repealed personal and dependent exemptions, and in the place of personal exemptions, TCJA nearly doubled the standard deduction. Taxpayers can still deduct state and local (“SALT”) real estate, personal property, and either income or sales taxes in tax years after 2017, but the TCJA capped the total SALT deduction at $10,000 for tax years 2018 through 2025.

One area unaffected is the tax break for qualified small-business stock. This tax break has been around since the 1990s but was little used before because capital gains rates were lower, corporate taxes were higher, and the percentage that could be excluded was capped. The tax-free exclusion for the sale of qualified small-business stock (QSB) should not be overlooked. This tax break is an incredible way to exclude a large amount of income.

To qualify for this tax break, you invest in a company with assets valued under $50 million (when the investment is made—not when it is sold), and you become eligible to exclude from your taxes $10 million or 10 times your investment, whichever is higher. This technique can be used by any investor and is ideal for employees at start-ups who are given stock as part of their compensation plan.

There are restrictions. The stock must be held for 5 years. Section 1202 of the Internal Revenue Code also sets out the rules. The QSB has to be stock of a c-corporation and the issuing company has to be in certain industries: Firms in the technology, retail, wholesale, and manufacturing sectors are eligible as QSBs, while those in the hospitality industry, personal services, the financial sector, farming, and mining are not…shucks, that means law firm stock is not eligible because it is a personal service. Review us on Google The exclusion percentage for QSB stock sales has increased over the years. When this Code section was enacted in 1993, the exclusion was 50%. If the QSB stock was acquired after Sept. 27, 2010 the exclusion percentage is 100%.

How much is the exclusion worth? With the capital gains rate at 20 percent and a net investment income tax of 3.8 percent on top of that, an investor who reaches the $10 million limit can save an extra $2.4 million.

North Carolina follows the Section 1202 100% tax exclusion on capital gains from the sale of QSBs. Therefore, capital gains on the sale of QSBS will not only be excluded from federal income taxes, but also state income taxes (currently 5.25% or $525,000 on a $10 million capital gain) if all of the guidelines are followed. North Carolina also allows a tax credit equal to 25% of the purchase price paid of stock in a Qualified Business (as defined) up to a maximum of $50,000.When starting a business, many advisors and clients have been focused on S-Corps and partnerships for the income pass-through features. However, given the lower corporate tax rates and the developments in Section 1202, noted CPA Alan LaPierre believes that advisors and new business owners should also consider a C-corp status when creating a new business.

Some may view the Section 1202 exclusion as a tax-free boon, especially if capital gains rates are increased to have the same marginal brackets as ordinary income tax rates. But, this often forgot exclusion is narrowly construed by the IRS and has come into vogue now that the exclusion percentage has increased and capital gains rates have been increasing.

This QSB is complicated and there are many details that this blog does not cover. We recommend you work with a tax professional in considering whether this opportunity is right for you. You can contact your attorney at Strauss Attorneys, PLLC and we can discuss this opportunity with you and involve professionals who understand and implement QSB strategies.