Consider Incorporating to Leverage Capital Gain Exclusion

By Marcia Richards Suelzer, Toolkit Staff Writer

Incorporating your business now may yield a surprising result when you sell it in the future: You won't have to pay tax on gain from the sale!

Back in September 2010, Congress passed a "small business jobs act." In that law, tucked deep in the recesses of the Internal Revenue Code, is a provision designed to spur business growth by providing a tax break for those who invest in small business stock. Right now, an individual can exclude 100 percent of the gain realized from the sale of certain small business stock.

Example. You invest $1,000 in Big-Multinational-Corporation (BMC). Five years later you sell your stock for $101,000, which is a gain of $100,000. Assuming a long-term capital gains tax rate of 25 percent, you will owe $25,000 in tax on the sale. However, if you purchase $1,000 worth of shares in Mom-n-Pop, Inc. (a very small business), and you sell the stock for $101,000 in five years, you will not owe any tax on the gain from the sale of the shares. You can pocket the $25,000 instead of paying it to Uncle Sam.

This creates an extraordinary opportunity for you to incorporate your business, hold onto the stock for the required period of time and then sell the stock without paying any tax on the gain you realize. Also, while you must acquire the stock at its original issuance, your tax break is preserved if the stock is transferred by gift or upon your death. Your holding period carries over to the transferee.

Act Now. While there are many tax and non-tax ramifications to consider before incorporating your business to take advantage of the exclusion of gain upon the sale of the stock, here are some circumstances when it merits serious investigation:

• Your business is thriving and you see great growth potential--this is a great way to ensure the appreciation in value is tax free when you exit the business;
• You want to make it easy to transfer your business to your children or other family members--the exclusion from income applies to gifts of stock; or
• You have key employees that you want to compensate--by making them shareholders you can foster the relationship while providing them with an opportunity for tax-free income.

If any of these apply to you, it's time to talk over your options with a business advisor.

Certain Conditions Apply

Of course, it's tax law that provides this benefit, and that means there are conditions that must be met in order to take advantage of the exclusion. The major requirements are as follows:

• Type of business. The business:
• must be a regular C corporation;
• must have $50 million or less in capital;
• must use 80 percent of the value of the corporate assets in the active conduct of business; and
• must not be a personal services business, banking or finance business, leasing business, hospitality business, farming or mining business
• Acquisition of stock. You must acquire the stock:
• before January 1, 2012;
• at its original issue;
and
• using money or contributed property (not other stock) or as compensation for services to the corporation.
• Holding Period. You must hold the stock for more than five years.

With planning, most small business owners will be able to meet these conditions.

While the exclusion on gain is generous, it is not unlimited. For any tax year, you are able to exclude the greater of 10 times your adjusted basis in the stock or $10 million (reduced by any amounts previously excluded). However, dispositions of stock can be structured to maximize the exclusion.

Even with conditions and limitations, this is a planning opportunity that does not happen often. And, it is one definitely worth your time to investigate.

Posted May 2, 2010.