Tax Guy: It’s a tough time for small businesses. This tax strategy could help yours survive and thrive

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The economic fallout from the COVID-19 crisis will produce business losers. Lots of them. Sad but true. The COVID-19 era will eventually end, but it could take years. Between now and then, I predict that many businesses and their customers will take unprecedented steps to protect themselves from whatever comes next. Even if it turns out that nothing really bad comes down the road anytime soon, steps will still be taken — as insurance. Good idea, IMHO.

Bottom line: The old normal will be replaced by a new post-COVID-19 normal that’s significantly different. The transition from old to new will produce business winners, and many will come from America’s small business sector. This column explains why operating as a tax-favored qualified small business corporation (QSBC) can help eligible businesses survive and thrive in the new normal.

But first, indulge me in some optimistic brainstorming about the kinds of new-normal opportunities that may present themselves. Here goes.

New-normal small business opportunity speculations

* Surge in small business fabrication and manufacturing to reduce or eliminate supply-chain risks that now exist for critical machinery, equipment, components, and personal protective equipment (PPE) for first responders and healthcare workers, and so forth. Big business will not be agile enough to exploit all the opportunities. You can take that to the bank.

* Surge in demolition, construction, remodeling, and expansion efforts to re-purpose commercial buildings and their surroundings to allow for social distancing and to create outdoor spaces for restaurants, bars, live entertainment, and so forth. And related paving and repaving work. These types of projects have always been fair game for small businesses.

* Surge in private residence remodeling and additions to accommodate family members the next time something goes terribly wrong and to accommodate out-of-work or under-employed adult children.

* Surge in private residence remodeling and additions to accommodate working from home and create space for home gyms and home theaters.

You get the idea.

Qualified small business corporation (QSBC) tax angles

If the existing QSBC federal income tax advantages are allowed to stand for the aforementioned kinds of activities, operating your small business as a QSBC could be a really good idea. Here’s why.

Tax-free treatment for eligible QSBC stock sale gains

QSBCs are the same as garden-variety C corporations for tax and legal purposes — except shareholders are potentially eligible to exclude 100% of their stock sale gains from federal income tax.

That translates into a 0% federal income tax rate on QSBC stock sale profits. Nice. However, you must own QSBC shares for over five years to cash in on this almost unbelievably good deal, and not all shares will meet the tax-law description of QSBC stock. Finally, there are limitations on the amount of QSBC stock sale gain that you can exclude in any one tax year, but the limitations are unlikely to apply and we won’t worry about them here. Your tax adviser can fill in the blanks.

Stock acquisition date is key

The 100% federal income tax gain exclusion privilege — which translates to a 0% federal income tax rate — is only available for sales of QSBC shares that were acquired on or after 9/28/10. So, shares issued recently, semi-recently, or after you read this can potentially be classified as tax-favored QSBC stock.

If you currently operate your business as a sole proprietorship, single-member (one-owner) LLC treated as a sole proprietorship for tax purposes, partnership, or multi-member LLC treated as a partnership for tax purposes, you’ll have to incorporate the business and issue yourself shares to attain QSBC status for the business. This assumes that QSBC status is, in fact, available if you incorporate. More on that later.

Key point: The act of incorporating a business should not be taken lightly. Please talk to your tax adviser before taking that step.

Key point: The gain exclusion break is not available for QSBC shares owned by another C corporation. However, QSBC shares held by individuals, LLCs, partnerships, and S corporations are potentially eligible.

Five-year holding period requirement

To be eligible for the 100% stock sale gain exclusion deal, you must hold your QSBC shares for over five years. For shares that have not yet been issued, the 100% gain exclusion break will only be available for sales that occur sometime in 2025 or beyond.

TCJA further sweetened the deal

The 2017 Tax Cuts and Jobs Act (TCJA) permanently installed a flat 21% corporate federal income tax rate for 2018 and beyond, assuming no backtracking by our duly elected D.C. politicians. So, if you own shares in a profitable QSBC and you eventually sell those shares when you’re eligible for the 100% gain exclusion break, that flat 21% corporate rate could be all the income tax that’s ever owed to Uncle Sam. Good.

What counts as QSBC stock?

To be classified as tax-favored QSBC stock, your shares must meet a bunch of requirements set forth in Section 1202 of our beloved Internal Revenue Code. Those requirements include the following:

* You must acquire the shares after 8/10/93 and they generally must be acquired upon original issuance by the corporation or by gift or inheritance.

* The corporation must be a QSBC on the date the stock is issued and during substantially all the time you own the shares.

* The corporation must actively conduct a qualified business. Qualified businesses do not include rendering services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, other businesses where the principal asset is the reputation or skill of employees; banking, insurance, leasing, financing, investing, or similar activities; farming; production or extraction of oil, natural gas, or other minerals for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business.

* The corporation’s gross assets cannot exceed $50 million immediately after your shares are issued. If after the stock is issued the corporation grows and exceeds the $50 million threshold, the corporation will not lose its QSBC status for that reason.

Key point: Before concluding that you can operate your business as a QSBC, talk to your tax adviser. I’ve summarized the most important QSBC eligibility rules here, but there are more.

The last word

The 100% federal income tax stock sale gain exclusion break (unique to QSBCs) and the flat 21% corporate federal income tax rate are two strong incentives for eligible small businesses to operate as QSBCs — in the COVID-19 era and beyond. However, this is an election year, and who knows what the Internal Revenue Code will look like after the election? Nobody. There are no guarantees. If you’re interested in the QSBC idea, talk to your tax pro, place your tax-planning bets, and hope for the best.

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