Code Section 1202 is not a new law; in fact it’s been around in its current state for some time. The original law stated that non corporate investors may exclude up to 50% of gain they realize on the disposition of qualified small business stock issued after August 10, 1993 and held for more than 5 years. In early 2009 to help stimulate the economy, the section 1202 exclusion was raised from 50% to 75% on gains from the sale of certain small business stock issued after February 17, 2009 and before January 1, 2011. Small business stock, as defined in this code section, is any stock in a C corporation which is originally issued after August 10, 1993. The stock must be originally issued to the taxpayer by a corporation that is a “qualified small business” on the date of issuance. A “qualified small business” generally must be a domestic C-corporation and have aggregate gross assets not exceeding $50 million. Also, at least 80% of the value of the corporation’s assets must be used in the active conduct of a qualified trade of business, which does not include professional service organizations.
In September 2010, the Small Business Jobs Act of 2010 increased the exclusion again to 100% of qualifying gain for qualified small business stock purchased between September 27, 2010 and December 31, 2010 and held for more than 5 years. The 100% exclusion of gain will apply the disposition of qualified stock of any single issuer subject to a cumulative limit for any given tax year equal to the greater of: (1) 10 times the taxpayer’s adjusted basis in all qualified stock disposed of during the taxable year (additions to stock basis made after issuance are disregarded); or (2) $10 million ($5 million for married taxpayers filing jointly), reduced by the total amount of eligible gain taken in prior tax years. Ultimately, this amendment to Code Section 1202 provides a federal capital gains tax rate of zero as long as all requirements are met.
Code section 1202 also benefits those taxpayers in Alternative Minimum Tax (AMT). Originally 42% of the excluded gain was an AMT preference item. For stock whose holding period began after December 31, 2000, 28% percent of the excluded income is included in calculating AMT. The 2003 Act reduced the AMT inclusion amount to 7% for dispositions on or after May 6, 2003. The 2010 Act further reduced the 7% AMT amount to 0%; allowing the excluded gain from these investments to be excluded as a preference item for AMT purposes.
The question is a whether a new company that is starting up should form as a C Corporation or a Limited Liability Company (LLC) or S Corporation if they will be taking in investment money before December 31, 2010. The answer is not straightforward and needs to be evaluated on a case by case basis. The main thing to keep in mind is that the purpose of Section 1202 is an incentive for the owners of a business and not necessarily the business itself. The reasoning is that Section 1202 requires that the business be formed as a C Corporation. A C Corporation is taxed at the entity level on its profits. Capital gains are afforded no benefit at the entity level over ordinary income.
While the benefit of paying no or limited tax on the sale of stock by individual investors in the future is appealing the question remains as to whether it is practical for the small business owned by one or a few individual owners. Keep in mind that to take advantage of the exclusion it must entail a sale of stock. More often than not buyer of businesses wants to buy assets rather than stock. Assets are depreciable or amortizable for tax purposes in the hands of a buyer, stock is not. Asset sales in a C Corporation setting create a tax at the corporate level as well as a tax at the individual lever when the company is liquidated. S Corporations and LLCs typically avoid this problem. However C Corporation owners often can persuade a buyer to purchase stock instead of assets if the sellers are willing to lower their price in order to compensate the buyer for lost tax benefits.
With this in mind there are a number of issues to consider that may favor C Corporation status:
- If the company is going to be going public and/or the investors will be selling stock after the 5 year holding period. Certainly if at the outset a company has the goal to take the company public it will be a C Corporation. In this case it would always make sense for the company to be a C Corporation and thus take the benefit of Section 1202.
- Is the company already set up as a C Corporation? If the company is a C Corporation from the beginning it should remain a C Corporation, unless S Corporation makes sense from a long term planning stand point. S Corporation typically makes sense for a company with fewer shareholders that are entirely made up of individuals. However if there are many shareholder, a shareholder that is not an individual or plans to continually bring in new owners, a C Corporation facilitates such activity. Remaining a C Corporation makes sense in such cases. Additionally a company that is already a C Corporation will rarely want to convert to an LLC because such conversion is treated as an asset sale followed by a liquidation. Such a conversion creates a tax at the corporate level and at the shareholder level as if the company was actually sold outright.
- If the company is going to be selling stock to another company it may make sense to be a C Corporation. As mentioned above an S Corporation cannot have a company as a shareholder. However, an LLC can have a company as an owner. Since this is the case this item in and of itself is not determinative of whether a company should be an LLC or a C Corporation.
- If the shareholders definitely plan to sell stock to a third party after holding it for the 5 year holding a period a C Corporation may certainly make sense. However, for closely held businesses with few owners this option may be beyond the control of one shareholder. All owners need to be on the same page for this to work. This position favors a C Corporation with many shareholders who are at liberty to sale their stock without restrictions. A company with few shareholders will want to be fairly certain they plan to sell the company and can do so in a stock sale rather than an asset sale after the required holding period is met.
- Simplicity is another reason that a C Corporation makes more sense than an LLC or even an S Corporation. Since income does not pass through to the owners taxes are taken care of at the corporate level. There is no need to worry about distributing cash to owners for tax purposes, none of the restrictions on fringe benefits that are imposed on LLCs and S Corporations, no issue for phantom income passing through to owners in years where there may be taxable profits but cash flow that is insufficient to meet the demand of the tax burden.
The above items seem to be the most compelling reasons for opting for C Corporation over an LLC or S Corporation. But a further discussion of LLCs and S Corporation is worthwhile. The advantage of either of these entities is primarily the one level of tax. If the business is not going to be involved in any of the items listed above that are favorable to the C Corporation structure and LLC or S Corporation may make more sense, even in light of the exclusion from tax that is available for C Corporations under Section 1202. And the preferable choice is an LLC that is taxed under the partnership tax regime. Such LLCs offer the maximum flexibility of not only having one level of tax, but of moving from the LLC structure to a corporate structure at some future date if desired with the minimum tax of tax consequences. There is flexibility for type of owner as well as the ability to attract investors that are limited partners. An LLC allows for flexibility in allocations of income and losses where a C or S Corporation do no. Most important is the one level of tax on the sale of the company. From a tax standpoint, typically an LLC is the most favorable form of doing business for businesses that are owned by a few number of owner operators and/or outside investors. The LLC is more attractive even given the Section 1202 exclusion if the plans for the business are uncertain and there are not the criteria outlined above that seems to favor a C Corporation.
Certainly the discussion points in this article are not totally comprehensive. Other facts and circumstances will need to be considered on a case by case basis to determine the proper entity selection for any new business. Consultation with competent tax professionals is crucial for each unique situation before the determination of the proper entity can be made.