Formation of Business Entities
In the U.S., the process of incorporation is called company formation or registration. Under U.S. and most international law a company or corporation is considered a separate entity to the people who own or operate the business.
Today, the majority of U.S. companies are formed electronically. Companies can be created by individuals, specialized agents, attorneys, or accountants. Many attorneys and accountants subcontract incorporation out to specialized company formation agents. Most agents offer company formation packages for less than $100, and some have packages below the cost of paper filing which is about $20.
IRC Section 1202 Exclusion of Gain on Qualified Small Business Stock: Considerations when Choosing the Entity
By Sabrina Blomquist, LL.M.T.
INTRODUCTION
An organizer of a new business must take into consideration many factors when determining what legal form a new business should take. Liability protection, asset appreciation, and tax consequences are just a few of the issues that must be considered. After determining what form a new business should take, developing an exit strategy allows taxpayers to plan for, and minimize, the tax consequences of dissolution.
The traditional tax treatment of capital gain from the sale of stock has lead to many business owners electing to structure their business entity as an S-corporation. A 2010 law targeted at encouraging new investment ventures expands Internal Revenue Code Section 1202 creating a brief window of opportunity for certain business entities with subsection C status to fully exclude future tax gains on the disposition of stock. This article provides a brief overview of the most common types of business entities and their methods of dissolution, provides in depth analysis of the changes to Code Section 1202, and concludes with a discussion of how these changes impact immediate formation and exit strategies for C-corporations.
CONSIDERING THE EXIT STRATEGY
Before determining the legal form a business will take and the tax implications thereof, a business organizer should consider its exit strategy. When the organizer determines whether its exit strategy is to sell the company, take the company public, or any other sort of exit strategy, it must then consider what effect the legal form of the entity will have on this exit strategy.
For instance, if the organizer determines that it wishes to eventually sell the company it would need to determine if a stock or asset sale would be preferable. As explained more fully below, sellers often prefer stock sales because no liability remains with the seller after the sale, whereas buyers prefer asset sales because they can determine which liabilities they will and will not assume. That being said, it may be impossible or impracticable for some sellers to engage in an asset sale because of the nature of the sellers business and the contracts and/or licenses associated therewith.
Many government contracts and contracts with third parties prohibit asset sales without the consent of the non-seller parties to the contracts. In addition, many licenses held by businesses cannot be transferred in a sale of assets. Thus a sale of stock can often cure the problem. In a sale of stock the parties to the contract do not change nor do the holders of the license because the company remains intact. Instead, merely the underlying shareholders of the company changes in a stock sale. Companies in industries that rely heavily on non-assignable contracts with third parties and/or licenses can avoid breaching the contract through assignment because the original party to the contract or the licensee, the company, remains the same. Thus, while most sales of companies are asset sales, those company organizers that know the company will depend heavily on large non-transferable contracts or licenses should structure the company so that an eventual sale of stock is possible.
If the organizer determined that it preferred to raise additional capital and take the company public in the future instead of sell the entire business, some forms of entities would make this much more difficult. If the company were a C-corporation it could easily engage in an initial public offering. If instead the company is an S-corporation, problems arise with the number and type of shareholders who might be owners and thus a company would need to go through the process of converting to a C-corporation before going public. LLC’s and partnerships do not allow for the flexibility that a corporate entity does and thus would not be the preferred choice for organizing an entity when the plan is to eventually take the company public.
Once the business’s organizer has determined which type of entity is best with regard to the projected exit strategy, the organizer should next determine if that entity structure is still preferable in light of the potential tax consequences and liability of the owners.
DETERMINING THE LEGAL FORM
When an organizer must considers liability protection, asset appreciation, and tax treatment with respect to the new business, it is important that the organizer understand not only the mechanics of each legal form, but also the needs of the owner/taxpayer.
Sole Proprietorships and Partnerships
Many taxpayers want to protect their personal assets from liabilities incurred by their business. Sole proprietorships and partnerships are not regarded as a separate legal entity from the taxpayer and offer no liability protection. As such, personal assets may be used to satisfy liabilities against the business. Because proprietorships and partnerships are treated as an extension of its owners, the entity is disregarded for tax purposes and not subject to double taxation. Income generated by the sole proprietorship or partnership passes through the entity to the taxpayer. This means the individual taxpayer pays tax on the income and not the entity itself. For taxpayers uncomfortable with the risk of personal liability, LLCs, C-corporations, and S-corporations may be preferable. If a sole proprietorship or partnership dissolves, it will be taxed in terms of capital gains, and all other assets will be treated as personal income.
Limited Liability Companies
LLCs provide the protection of limited liability and the tax consequences of a partnership. Members of an LLC may be individuals or business entities. Like a partnership, income generated by an LLC flows through the entity to the Members and is subject to tax only once . As their name implies, LLCs provides limited liability for members. Personal assets will not be used to satisfy liabilities generated by the business. It is important to note, however, that the Code does not distinguish income derived by an LLC as either active income or passive income; it is all just considered income. Active income includes salaries and income generated from performing job-related tasks. Passive income includes rental, royalty, and rental income to the business not earned performing job-related tasks. Passive income in a partnership is not subject to self-employment tax. Because the Code does not distinguish between the active and passive LLC income, the entire amount of income earned by the LLC is subject to self-employment tax even if only a portion of the income was attributable to active income. Owners of single member LLCs must pay self-employment tax on income generated by the LLC and must make quarterly estimated payments to the IRS.
C-corporations
C-corporations provide liability protection because C-corporations are viewed as a separate legal entity apart from its owners. Shareholders of C-corporations are subject to liability only to the extent of their investments in the corporation. C-corporations may raise capital with the sale of shares, in addition to the income generated from operations. Income generated by the corporation is taxed at a corporate rate which may be lower than the personal rate LLCs and S-corporations are subject to. Corporate income is taxed once on the corporate level and again to shareholders when distributed to them as dividends. While C-corporations have been traditionally viewed as less desirable because their profits are subject to double taxation, the tax rate on dividends was significantly lowered with the enactment of the Jobs and Growth Relief Act of 2003, lessening the negative impact of double taxation.
S-corporations
Corporations may elect to be treated as an S-corporation for tax purposes in order to enjoy the benefits of incorporation but avoid double taxation. S-corporations retain the corporate characteristic of limited liability for shareholders, preventing owners from being liable for more than the amount of their investment. S-corporations are taxed much like partnerships because profits and losses flow through to the shareholders whether they receive any distributions or not. To qualify for subchapter S status, the corporation cannot have more than 100 shareholders, there must be only one class of stock, and profits and losses must be distributed to shareholders in proportion to their interest. Sellers of an S-corporation avoid the double taxation a C-corporation is subject to if the S-corporation shareholder satisfies the prescribed holding period.
Conversion from C to S Status
C-corporations wishing to convert to subchapter S status need to be aware of the tax consequences of such an election. Tax on built-in gain applies when the corporation sells any asset that had built-in gains at the time the S election became effective if the property with built-in gains is sold within 10 years after the corporation becomes an S-corporation. This 10 year holding period was temporarily shortened to 5 years by the Small Business Jobs Act of 2010. Former C-corporations are subject to a special tax if the company’s passive investment income exceeds 25 percent of its gross receipts, and the corporation has accumulated earnings and profits carried over from its C-corporation years. Unused net operating losses cannot be used to offset S-corporation income, nor can it be passed through to shareholders. If the losses cannot be carried back to an earlier C-corporation year, they cannot be claimed. Strategies to eliminate or minimize the tax consequences of a conversion depend on the corporation’s individual circumstances.
Entity Sale vs. Asset Sale
When selling a business, owners must choose between conducting an entity sale or an asset sale. Careful consideration must be given when choosing between these two methods because specific liabilities and tax consequences result from either choice. An entity or stock sale transfers shares of corporate stock or LLC membership interests to the buyer. The business’s non-stock assets, such as inventory or real estate, continue to be owned by the entity now owned by the new shareholders/members. An asset sale transfers the business’s assets to the buyer while the seller maintains ownership of the business’s stock or membership interests. Specific assets may be expressly included or excluded from an asset sale agreement.
The transferability of liability plays a significant role in determining a business’s preferred method of sale. An entity sale transfers the business’s liabilities to the buyer. Because the buyer then controls the company, the buyer assumes any liabilities that may exist. A sale of assets, on the other hand, does not transfer liability to the buyer. As such, sellers will likely prefer entity sales because they will be relieved of the company’s known and potential liabilities, while buyers are obliged to conduct greater due diligence.
An asset sale typically permits buyers to receive depreciation benefits sooner than if they had entered into an entity sale. Sellers benefit as a result of being taxed at the long-term capital gain rate. Asset sales of C-corporations may be subject to double taxation. Adjusting the sale price or payment terms can help offset this burden.
INTERNAL REVENUE CODE § 1202: PARTIAL EXCLUSION FOR GAIN FROM CERTAIN SMALL BUSINESS STOCK
History of IRC § 1202
Internal Revenue Code § 1202 was enacted in 1993 to stimulate investment in small businesses, startups, and specialized small businesses investment companies. It excluded from gross income a portion of the gains realized on the disposition of qualified small business stock held for more than five years. However, the usefulness of Section 1202 was limited by the fact that 42 percent of the excluded gain was an alternative minimum tax (AMT) preference item (meaning the gain must be added back in to income for AMT purposes). Code §57(a)(7) was amended in 2003, reducing the amount of excluded gain included in Alternative Minimum Tax Income (AMTI) to only 7 percent. The American Recovery and Reinvestment Act of 2009 increased the amount of excludable gain from the sale or exchange of qualified small business stock from 50 percent to 75 percent. This increase applied to stock acquired after February 17, 2009 and before January 1, 2011 .
Section 1202 was again amended with the enactment of the Small Business Jobs Act of 2010. This increased exclusion only applies to qualified small business stock acquired after September 27, 2010 and before January 1, 2011 and held for more than five years. The new Act also provides important AMT relief. Prior to the new Act, seven percent of the excluded gain was treated as an AMT preference item. Under the new Act, gain from the sale or exchange of qualified small business stock falling under the new 1202 provisions will not be considered an AMT preference item. This means that eligible gain is excluded from both regular taxable income as well as AMTI.
Cumulative Limit on Excludable Gain
Section 1202 imposes a cumulative limit on the excludable gain from the sale or exchange of qualified small business stock. The gain may not exceed the greater of:
• $10 million reduced by the aggregate amount of eligible gain realized in prior taxable years attributable to dispositions of stock issued by such corporation; or
• 10 times the aggregate adjusted basis of qualified small business stock issued by such corporation and disposed of during the current taxable year.
Additions to the basis are disregarded, which may substantially limit the tax benefit of this provision. Additionally, the $10 million limitation applies on a shareholder by shareholder basis. Any property contributed to the issuing corporation us valued at its fair market value as of the date of contribution. Married taxpayers who file separately will be allocated $5 million of eligible gain.
QUALIFIED SMALL BUSINESSES
To qualify as a small business under Section 1202, an entity must be a domestic C-corporation, not an LLC, with aggregate gross assets under $50 million both before and immediately after the issuance of the stock. This means that gross assets cannot exceed $50 million at the time of investment, including any capital raised by issuing the stock. Corporations that are members of the same parent-subsidiary control group are treated as the same taxpayer for purposes of Section 1202. The adjusted basis of property contributed to the corporation shall be determined as if the basis of the property were equal to its fair market value at the time of such contribution.
Qualified Trade or Business Requirement
To qualify as a under Section 1202 the corporation must use 80 percent (by value) of its assets in the active conduct of a qualified trade or business during substantially all of the taxpayer’s holding period. Assets such as working capital, assets used in start-up activities, as described in Code Section 195(c)(1)(A), as well as activities related to research and experimental expenditures under Code Section 174 and 41(b)(4) expected to be used within the first two years of the corporation’s existence, will be treated as used in the active conduct of a qualified trade or business. It is important to note, however, that once the corporation has existed for two years, no more than 50 percent of its assets can be working capital or investments held for future research. Computer software rights that produce active business royalties are also treated as an asset used in the active conduct of a trade or business. Activities that do not constitute a qualified trade or business include personal service businesses such as architectural, accounting, consulting, and law firms. Code Section 1202 also disqualifies banking, finance, or insurance businesses, farming businesses, and any business operating a hotel, motel, or restaurant.
Section 1202 also limits the portion of the corporation’s total value which consists of real estate owned by the qualified small business. A corporation will not be considered a qualified trade or business for any period during which more than 10 percent of the total value of its assets consists of real property which corporation does not use in the active conduct of a qualified trade or business. The mere ownership of, dealing in, or renting of real property shall not be treated as the active conduct of a qualified trade or business.
QUALIFIED SMALL BUSINESS STOCK
Original Issue Requirement
“Qualified small business stock” is stock acquired by the taxpayer at its original issue after August 10, 1993, either directly or through an underwriter, in exchange for money or other property not including stock, or as compensation for services provided, other than services performed as an underwriter of such stock. It is important to note that because the new stock may not be acquired in exchange for already existing stock, the gain exclusion does not apply to stock acquired through corporate reorganization. As previously mentioned, the stock must be held for more than five years before disposition.
While stock acquired from a person other than the issuer is generally disqualified, Section 1202 does provide a few exceptions. If the taxpayer receives stock in a corporation that was acquired solely through the conversion of other stock in such corporation, which is qualified small business stock, the stock received will also be considered qualified small business stock and shall be treated as having been held during the period during which the converted stock was held. In other words, the exchange of stock resulting from a conversion of the corporation does not transfers the ability to benefit from Section 1202 when selling the stock received in the exchange, if the exchange meets all of the requirements of Section 1202. Thus, the transferee who receives qualified stock by gift, bequest, or through a distribution from a partnership will be treated as acquiring the stock in the same manner as the transferor and will be treated as having held the stock continuously from the original date of acquisition.
Treatment of Pass-Thru Entities
Section 1202 also provides special treatment for noncorporate taxpayers holding an interest in pass-thru entities selling qualified small business stock. To exclude the gain, the qualified stock must be held by a pass-thru entity for more than five years and the taxpayer must have held an interest in the entity from the time the stock was acquired through its disposition. Section 1202 defines a pass-thru entity as any partnership, S corporation, regulated investment corporation, or common trust fund.
The Code also disregards the stock and debt in any subsidiary corporation, deeming the parent corporation to own its ratable share of the subsidiary’s assets, and to conduct its ratable share of the subsidiary’s activities. Section 1202 defines a corporation as a subsidiary if its parent owns more than 50 percent of the combined voting power of all classes of stock entitled to vote, or more than 50 percent in value of all outstanding stock of that corporation.
A corporation’s stock will not qualify for the exclusion if, at any time during the four-year period beginning two years before the date that stock was issued, the corporation purchased (either directly or indirectly) any of its stock from the taxpayer or any person related to the taxpayer.
The corporation may not exclude gain for any period during which more than 10 percent of the value of a corporation’s assets, in excess of liabilities, consists of stock or securities in other corporations which are not subsidiaries of that corporation. A de minimis amount can be redeemed, however, without rendering the stock ineligible for the exclusion. If the aggregate amount paid for the redeemed stock by corporation does not exceed either $10 million or 2 percent of all outstanding stock, the gain will still be excludable.
Incorporations and Reorganizations Involving Nonqualified Stock
Section 1202 encompasses incorporations and reorganizations where qualified small business stock is exchanged for other stock which would not qualify as qualified small business stock. Generally, in the case of a transaction described in Section 351 or a reorganization described in Section 368, if qualified small business stock is exchanged for stock which would not qualify as small business stock, the non-qualifying stock will be treated as qualified small business stock acquired on the date on which the exchanged stock was acquired.
Section 351 incorporations involve the transfer of property to a corporation by one or more persons solely in exchange for stock in that corporation, and the person making the exchange controls the corporation immediately following the exchange. The corporation recognizes neither gain nor loss for transactions involving these transfers.
Section 368 corporate reorganizations include:
• statutory mergers or consolidations;
• the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation;
• the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all of the properties of another corporation, but in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a liability of the other shall be disregarded;
• a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders, or any combination thereof, controls the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualified under Section 354, 355, or 356;
• a recapitalization;
• a mere change in identity, form, or place of organization of one corporation, however effected; or
• a transfer by a corporation of all or part of its assets to another corporation in a Title 11 or similar case; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under Section 354, 355, or 356.
Redemptions
Section 1202 also disqualifies small business stock if the corporation engages in a “significant redemption.” A redemption is considered significant if the corporation redeems stock with an aggregate value exceeding 5 percent of the aggregate value of the corporation stock within a two year period beginning one year before the issuance of the stock. Section 1202 provides another de minimis exception if either the aggregate amount paid for the stock does not exceed $10,000, or no more than 2 percent of all outstanding stock. Section 351 provides rules for determining whether the aggregate amount exceeds the 2 percent limit. The percentage of the stock acquired in any single purchase is determined by dividing the stock’s value (at the time of purchase) by the value (at the time of purchase) of all stock outstanding immediately before the purchase. If taxpayer acquires stock in multiple purchases, the sum of the percentages determined for each separate purchase.
IRC § 1202’s IMMEDIATE TAX CONSEQUENCES FOR C-CORPORATIONS
The purpose of IRC § 1202 is to encourage investment in new ventures. In the past, this provision was not often utilized because its tax benefits were largely nullified by the Code’s alternative minimum tax provisions. The changes enacted by the Small Business Jobs Act of 2010 rendered Section 1202 a potent tool for favorable tax consequences when dealing with capital gain from the sale of stock. Code Section 1202 allows for exclusion of 100 percent of the gain from qualified stock acquired after September 27, 2010 and before January 1, 2012.
The changes to Section 1202 create a temporary opportunity for C-corporations to take advantage of tax treatment otherwise reserved for S-corporations and LLCs. If a C-corporation can satisfy the requirements listed in Section 1202, it may be able to exclude all of its gain from the sale of qualified stock. This development changes entity formation and exit strategies for C-corporations even if only temporarily. Conversion to an S-corporation, for example, may not be necessary to take advantage of the exclusion if the business qualifies as a small business as defined by Section 1202.
Another example is the choice between an entity and an asset sale. If a taxpayer wanted to utilize the 1202 exclusion, an entity sale would be preferable since the gain from the disposition of qualified stock would be fully excludable.
CONCLUSION
The purpose of Section 1202 has always been to encourage investment in new ventures. With the increased exclusion of eligible gain, investing in qualified small businesses provides a unique opportunity for financial gain and favorable tax treatment. This purpose may also extend to small businesses formed by the acquisition of stock from existing corporations or assets from existing benefits. While the window for selling qualified small business stock and therefore utilizing this exclusion has closed, it should be noted that the deadline was extended last year and, considering the country’s current economic depression, it is very likely that the January 1, 2012, deadline will be again extended. At least three bills extending the January 1, 2012 deadline have been presented to the Senate Finance Committee and of those three one asks that the legislature extend the deadline as far out as January 1, 2015.
NOTE: Change of Control provisions in contracts and licenses can act as an impediment for stock sales much the same way as the anti-assignment provisions act as an impediment to asset sales. If the exit strategy is sale and the business’s major contracts/licenses contain both such provisions, the eventual exit strategy may be less influential in the determination of the legal form because the sale is impeded either way.
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