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Corporation Articles and Resources

Section 1202

By: Ted Sutton, Esq.

Introduction

From a very young age, Elong Muskrat was always passionate about providing solutions to the world’s most difficult problems. Over the years, Elong had founded multiple companies in different industries. Many of them failed. However, some of them were wildly successful.

One day, Elong wanted to provide a solution to help reduce the world’s fossil fuel usage. Since cars contribute heavily to this use, Elong decided to start an electric car company. These electric cars would have all the same features without having to make the trip to the gas station.

After reducing his idea into a business plan, Elong formed Edison Electric Vehicles in 2011, a Delaware C-Corp, where he initially owned 100% of the stock.

In the following decade, Edison manufactured over 1 million electric vehicles. Because car manufacturing is an expensive endeavor, Edison’s gross assets were only worth $40 million.

In 2021, Elong was drawn to another serious issue. He noticed the ubiquity of social media and all of its negative impacts. Titter, a platform where users would constantly exchange a tit for tat, was the primary culprit. Elong wanted to purchase Titter and change its algorithms for the betterment of society. However, he would need to finance the purchase of Titter by selling his stock in Edison.

In 2022, Elong sold his stock in Edison to Riviera Motors, another electric vehicle maker, for $9 million. He then used that sum to finance his purchase of Titter.

Being an extremely smart person, Elong was curious as to the tax consequences of his stock sale. His tax advisor told him that he may qualify for the Qualified Small Business Stock (QSBS) exemption. If he does, he could save millions of dollars in taxes.

Qualified Small Business Stock

So what exactly is QSBS? Under Section 1202 of the Internal Revenue Code, a taxpayer may be exempt from paying capital gains tax when selling QSBS stock if they meet certain requirements. Each of these are listed below.

  1. QSBS Only Applies to C-Corp Stock

First, the stock must be held in a C-Corp. S-Corp stock, LLC units, and partnership interests are not eligible for the QSBS exemption.

Edison was formed as a C-Corp. The first requirement is easily met.

  1. The C-Corp Shares Must be Acquired in the Original Issuance

Second, the C-Corp shares must be acquired in the original issuance.

Because Elong owned 100% of Edison’s stock when he formed it, the second requirement is met.

  1. The C-Corp Must be a Qualified Small Business

Third, the C-Corp must be a qualified small business. A qualified small business is a domestic C-Corp which holds gross assets that have never exceeded $50,000,000.

Here, Edison’s gross assets were only ever worth $40 million. Because of this, Edison meets the definition of a qualified small business.

  1. 80% of the Firm’s Assets must be Used in Active Conduct

Fourth, a minimum of 80% of the firm’s assets must be used in active conduct, or in an ongoing business. If stock is acquired in a passive C-Corp, it cannot qualify for the QSBS exemption.

Because Edison manufactures cars, it easily meets the requirement of active conduct.

  1. The Stock Cannot be in Certain Lines of Business

Fifth, the stock of certain lines of business will not qualify for the QSBS exemption. Some of these include banking, insurance, farming, leisure and hospitality, and other professional businesses.

Because Edison manufactures cars, it does not fall into any of the aforementioned categories. It still qualifies for the QSBS exemption.

This is all great news for Elong. His stock qualifies for the QSBS exemption because it has met the aforementioned requirements. He can save money by not having to pay the capital gains tax associated with the sale of stock. However, how much Elong saves depends on when the stock was held and how much the stock sold for.

  1. When the Stock was Held

If the taxpayer acquires QSBS stock after September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 100% of the capital gain upon its sale.

If the taxpayer acquires QSBS stock between February 18, 2009 and September 27, 2010, and holds it for more than 5 years, the taxpayer can exclude 75% of the capital gain upon its sale.

If the taxpayer acquires QSBS stock between August 11, 1993 and February 18, 2009, and holds it for more than 5 years, the taxpayer can exclude 50% of the capital gain upon its sale.

Elong formed Edison in 2011 and sold his Edison stock in 2022. Because of this, Elong may exclude 100% of the gain.

  1. Maximum Excludable Gain Recognized

The IRS sets limits on how much a taxpayer can exclude upon the sale of QSBS stock. The maximum eligible gain that a taxpayer can recognize is capped at the greater of $10 million, or 10 times the aggregate adjusted basis in the stock.

Here, because Elong sold his Edison stock for $9 million, he is able to exclude the entire gain associated with its sale. 

Conclusion

If they meet the requirements, qualifying for QSBS can be advantageous to taxpayers who acquire and sell stock in smaller C-Corps.

C Corporation

What is a C Corporation?

illustration of a storefrontCorporations have been used for over 500 years to limit owners’ liability and thus encourage business investment and risk taking. Their use for this purpose continues to this day. 

You will hear about both C Corporations and S Corporations. Both are corporations with charters granted by the state of organization. You can organize in Nevada for the best asset protection laws, for example, and qualify to do business in California. In that case, you will have one corporation paying annual fees in two states (which many people do). While we like and often use S Corporations, we keenly appreciate the advantages of C Corporations. They certainly have their merit and a place in your entity structure strategy.

The C and the S refer to IRS Code Sections. C corps feature a double taxation – one tax at the company level and another tax on profits distributed to shareholders. This double tax is why many people consider S corps, which has only one level of tax. But there are restrictions on ownership of S corps, where as there are no such limits on C corps.

Here is a quick list of C Corporation advantages:

  • They can have an unlimited amount of shareholders, from anywhere in the world.
  • For Nevada and Wyoming corporations, officers and directors can reside anywhere in the world. This can be a boon for foreign investors. 
  • They can have several different classes of shares.
  • They have the widest range of deductions and expenses allowed by the IRS (more on this below).
  • They are the most widely recognized business entity in the world, and are the premier entity for going public.
  • In Nevada and Wyoming, nominee (or stand-in) officers and directors can be utilized, adding extra levels of privacy.
Image Link to download full c-corporation guide pdf

Tax Advantage: Wide Range of Deductions and Expenses

A C Corporation has the widest range of deductions and expenses allowed by the IRS, especially in the area of employee fringe benefits. A C Corporation can set up medical reimbursement and other employee benefits, and deduct the costs of running these programs, including all premiums paid. The employees, including you as the owner/shareholder, will also not pay taxes on the value of those benefits.

This is not the case in a flow-through entity, such as an S Corporation, LLC or LP. In each of those cases the entity may write off the costs of the benefits, but any employee/shareholder who owns more than 2% of the entity will pay taxes on the value of their benefits received. So, if having the maximum deductions and all of the employee fringe benefits on a tax-free basis is important to you, a C-Corp may be your entity choice.

Which type of business works well as a C Corp?

C Corporations are great for a business that sells products, has a storefront and employees, and may or may not have a warehouse where it keeps its inventory. C-Corps don’t work well with businesses that want to hold appreciating assets, such as real estate, because of the tax treatment on the sale of these assets.

Tax Disadvantage: Double Taxation Issues

The most often-cited disadvantage of using a C-Corp is the “double-taxation” issue. Double-taxation happens when a C-Corp has a profit left over at the end of the year and wants to distribute it to the shareholders as a dividend. The C-Corp has already paid taxes on that profit, but once it distributes the profit to its shareholders, those shareholders will have to declare the dividends they receive as income on their personal tax returns, and pay taxes again, at their own personal rates.

How to Avoid the Double-Taxation Scenario

There are many things you can do to avoid the double-taxation scenario:

  • Structure the C-Corp so that there are no profits left over – use all of the write-offs and deductions allowed by the IRS to reduce the C-Corp’s net income.
  • Offer great benefit plans!
  • Pay higher salaries to yourself and the other owner/employees than you would if you were using a flow-through entity such as an S-Corp. Yes, you will have to pay payroll taxes and personal income taxes on those monies, but you would pay personal taxes on dividends paid to you anyway. And it may be that in the big picture, the savings on one side outweigh the additional taxes paid on the other side.

The decision as to what entity is best for you really does, in so many cases, hinge on taxes, and that is why, with any corporate-related decision, you are wise to seek the advice and assistance of a good CPA.

Corporate Direct along with your CPA can help you decide which corporation is best for you.