How to Sell your Business (Almost) Tax Free: The Power of Qualified Small Business Stock

While practicing corporate law over the past two decades, some of my greatest joys have come celebrating with my clients after they’ve sold their businesses – often earning themselves sizable financial rewards. On the other hand, I find it tremendously frustrating to see how much of those rewards are often siphoned off to taxes, especially when their tax bill could have been drastically reduced, or practically eliminated altogether, with just a just little bit of strategic planning. It’s true! Imagine selling your business and legally avoiding a significant portion of federal income taxes on the sale. Thanks to the Internal Revenue Code (IRC) Section 1202, pertaining to Qualified Small Business Stock (QSBS), this scenario is not just possible, but highly achievable for eligible small business owners.

IRC Section 1202 was created to foster investment in certain small businesses by providing a tax incentive for investors. This incentive includes the potential to exclude up to 100% of the gains from the sale of QSBS, provided it has been held for more than five years, from federal income taxes. The amount of gain exclusion is determined by the date the stock was acquired and can range from 50% to 100%, capped at $10 million or 10 times the adjusted basis of the stock, whichever is greater. Importantly, this exclusion also extends to the Alternative Minimum Tax (AMT) and the excluded gain is not subject to the Net Investment Income Tax (NIIT), enhancing the benefit.

To be eligible for these benefits, the stock must be issued by a domestic C corporation whose assets do not exceed $50 million before and immediately after the issuance. (Importantly, LLCs, partnership and other entities are eligible to convert to a C corporation and take advantage of IRC Section 1202, although the timing of the conversion is critical to ensure eligibility and maximize tax savings.) QSBS rules further stipulate the stock must be held for more than five years. Additionally, at least 80% of the value of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer's holding period.

However, not all businesses qualify. Specifically excluded are service businesses where the primary asset is the reputation or skill of its employees, including fields such as health, law, and financial services. Also excluded are businesses involved in banking, insurance, farming, mining, hospitality, and any business that operates a facility for the production or distribution of energy.

For business owners, understanding whether your enterprise qualifies under IRC Section 1202 can provide a critical advantage when planning a sale. Structuring or restructuring a business to align with the requirements of QSBS status can attract more investors, given the tax advantages it offers. Additionally, timing the sale to align with the five-year holding period required can significantly increase tax benefits, making strategic planning essential.

The opportunity presented by IRC Section 1202 can be a game-changer for small business owners looking to maximize the proceeds from the sale of their business. Early planning and consultation with a knowledgeable business attorney can ensure that you meet the eligibility criteria to take full advantage of this provision. This strategy not only optimizes your financial outcomes but can also make your company more attractive to potential investors who can also benefit from these substantial tax savings.

For small business owners contemplating the sale of their business or seeking to understand how to qualify for QSBS benefits, the guidance of an experienced attorney is invaluable. Navigating these waters effectively requires detailed knowledge of tax law and strategic business structuring, ensuring that you are positioned to make the most of the opportunities available under IRC Section 1202.

About The Bain Firm, PLLC

At The Bain Firm, PLLC, we are committed to safeguarding the interests of entrepreneurs, executives, and business owners, while driving their success in every aspect of their ventures. If you're considering selling your business and would like help navigating its complexities, positioning your business for maximum value or legal advice for a smooth and successful transaction, contact us today for a complimentary consultation.