Can Your Clients Sell their C Corp Stock Tax Free?
by Al Statz
In some cases yes. Congress has long recognized that small businesses investment is an important driver of the U.S. economy. Back in 1993, to incentivize investors, they developed a rule that eliminates federal income tax on some (later revised to all) of the gain on the sale of certain C Corporation stock issued after August 10, 1993. As M&A advisors we should try to point out potential tax breaks to clients and in this article I’ll discuss Qualified Small Business Stock (or “QSBS”) from a business sale perspective.
QSBS Requirements
To qualify for this tax break, the client’s stock has to be deemed Qualified Small Business Stock per Internal Revenue Code Sec. 1202. Here’s a summary of those requirements:
- Must be a domestic C Corporation
- Stock was acquired at original issuance
- Was acquired after 8/10/1993
- Has been held for 5 years or more at the time of sale
- Is a small business, defined as assets of less than $50 million
- The company is NOT engaged in professional services that are dependent on the reputation or skill of one or more employees, financial services, farming, mining or resource extraction, hotels, restaurants or other similar businesses
Depending on the issue date of the stock, 50%, 75% or 100% of the gain (up to $10 million) may be excluded from federal income tax. The gain exclusion is 50% (subject to a 7% Alternative Minimum Tax (“AMT”) add-back) for stock acquired between August 11, 1993 and February 17, 2009. Stock acquired between February 18, 2009 and September 27, 2010 is eligible for 75% gain exclusion (subject to 7% AMT add-back), and stock acquired after September 27, 2010 receives a 100% exclusion, without an AMT add-back.
Andersen Tax offers a more complete list of QSBS requirements.
In case you’re wondering, the Tax Cuts and Jobs Act of 2017 did not alter QSBS rules, but the reduction of the federal corporate tax rate to 21% affects the magnitude of the QSBS benefit relative to a sale of assets.
M&A Perspective
Even if seller clients hold stock that meets QSBS requirements, they may not be able to benefit from the rule because as we know acquirers of small private businesses generally prefer to buy assets, not stock. For buyers, buying assets reduces their tax bill, improves their cash flow, and reduces potential legal liabilities. To forgo these benefits (i.e. ask buyers to buy stock) buyers usually expect a meaningful price discount.
Given the magnitude of the QSBS tax break, especially when eligible for 100% exclusion, a seller of QSBS could give a buyer a substantial price discount and still come out well ahead (compared to selling the company’s assets). Even Uncle Sam benefits in the long run.
Does your client have QSBS?
The prospect of selling qualified small business stock is compelling, however determining whether your client’s stock qualifies and claiming this benefit is not simple. They must work with a CPA that is well-versed in QSBS requirements and the steps needed to comply with them.
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Al Statz is founder and President of Exit Strategies Group, a California-based M&A brokerage and business valuation firm. For further information Al can be reached at [email protected] or 707-781-8580.
