The Tax Benefits of Investing in Small Businesses

Transcription

1 The Tax Benefits of Investing in Small Businesses By John Welsh Vice President, Wealth Strategy Pam Lucina Managing Director Justin Miller Senior Director BNY Mellon Wealth Management Small businesses are anything but a small part of the overall U.S. economy. According to a 2016 report from the U.S. Small Business Administration, 1 businesses with fewer than 500 employees make up 99.7% of all U.S. businesses with paid employees, and account for 63.3% of net new jobs. Recognizing that small businesses drive the economy, produce jobs and lead innovation, Congress has enacted several laws over the years designed to encourage investments in small businesses. One such incentive is known as the Qualified Small Business Stock (QSBS) exclusion. 2 This tax benefit allows qualified investors to exclude a portion of gains from sales of QSBS when their investment meets certain requirements, which can provide significant savings and ultimately increase the after-tax cash proceeds. The QSBS exclusion can also be a valuable incentive for small businesses raising money from outside investors, such as venture capitalists and angel investors, and for recruiting or rewarding key employees. Small business owners and investors should work closely with their financial and tax professionals to understand the many technical requirements of the QSBS exclusion. For those businesses that meet the qualifications, this exclusion can be extremely beneficial for entrepreneurs and investors. HOW THE INCENTIVE HAS EVOLVED OVER TIME The original QSBS exclusion, enacted in 1993, excluded 50% of the gain on the sale of QSBS, capped at the greater of $10 million or 10 times the investor s tax basis in the stock. At the time, the maximum capital gains rate was 28%, so this amounted to an attractive 14% effective tax rate on QSBS capital gains. 1 U.S. Small Business Administration Office of Advocacy, SB-FAQ-2016_WEB.pdf. 2 The QSBS exclusion was established as part of Internal Revenue Code (IRC) Section 1202 and is also known as the Section 1202 exclusion.

2 IN SMALL BUSINESSES // 2 While the cap of $10 million or 10 times the basis has remained constant, the percent of the gain that can be excluded and the maximum capital gains tax rate have fluctuated over the years. Decreases in the maximum capital gains tax rate in 1997 and 2003, together with the market downturn in 2008 and 2009, significantly weakened the effectiveness of the incentive, leading Congress to take action to improve it. For purchases of QSBS in 2009 and 2010, the percentage of gains on the sale of QSBS that can be excluded was raised to 75% and 100%, respectively, depending on the date the stock was acquired. The impact of the incentive was enhanced further in 2013 when the maximum capital gains tax rate was increased to 20% and the 3.8% net investment income surtax was created. HOW THE QSBS EXCLUSION WORKS TODAY Investors can exclude a portion of the gain from the sale of QSBS when the investment and transaction otherwise meet the requirements of the law. Qualified Stock The company issuing the stock must be a domestic C corporation that uses at least 80% of its assets actively conducting a qualified trade or business. There is no specific definition for what a qualified trade or business is, but certain types of businesses are clearly excluded in the statute. These include, but are not limited to, companies engaged in banking, finance, insurance, farming, mining, restaurants, hotels, and professional services including health care, law, engineering, architecture, consulting, accounting and similar businesses. Additionally, the company issuing the stock must have maintained aggregate gross assets of less than $50 million at all times from August 10, 1993, through immediately after the stock was issued. Qualified Investor While a qualified small business must be a C corporation, an investor wishing to claim the QSBS exclusion cannot be a C corporation. In addition, the investor must have acquired the stock directly from the issuing company in exchange for money, property or services. Stock purchased on the secondary market does not qualify. Holding Period The investor must have held the stock for at least five years prior to the sale or exchange. There s no requirement to file anything with the IRS when the stock is acquired. An investor who wants to take advantage of the QSBS exclusion can simply note on his or her tax return that the transaction is eligible for the Section 1202 exclusion. It should be noted, there are specific rules regarding the holding period if the stock is acquired another way (e.g., as a gift or inheritance, stock options, restricted stock, convertible stock or debt, among other transfers). It is best to consult a tax professional prior to any transaction to determine the tax impact.

3 IN SMALL BUSINESSES // 3 Exclusion Amount To determine how much of the capital gain can be excluded, investors will need to know the date the qualified stock was acquired. Date Stock Acquired Excluded Amount 8/10/93 2/17/09 50% 2/18/09 9/27/10 75% On or after 9/28/10 100% For stock purchased prior to September 28, 2010, the unexcluded portion would be subject to a 28% tax rate. Regardless of when the stock was acquired, investors may only exclude gains up to the greater of $10 million or 10 times the investor s basis in the stock. Gains greater than that amount will be subject to the maximum capital gains rate (23.8% in ). While a portion of the gains on stock purchased or acquired prior to September 28, 2010 does not incur capital gains tax, 7% of the excluded gain is subject to the alternative minimum tax (AMT), which could erode the benefits of investing in a qualified small business. CAVEATS & CONSIDERATIONS Small business investors and entrepreneurs should be aware of several additional factors that can impact whether, and to what extent, the QSBS exclusion may apply. Investors First, when making an investment, ask the issuing company to certify in writing that it meets the definition of a qualified small business. Be sure to also maintain accurate records of investments, including the date of purchase and the purchase price. Remember that the holding period to qualify for the QSBS exclusion is five years, so plan sales accordingly. However, all hope isn t necessarily lost even if you re selling stock before the five-year period is up. If you held stock in a qualified small business for at least six months, rolled those proceeds into the stock of another qualified small business within 60 days of the sale and meet certain other requirements, you may be able to defer the gain on the sale. Your tax professional can help you determine whether this is an available option. Finally, even if the qualified small business you invested in was acquired before the end of the five-year holding period, your investment may still qualify for the exclusion. If the acquiring business was also a qualified small business and your original stock was exchanged for stock in the new company, the QSBS exclusion should still be an option. Entrepreneurs If you re establishing a small business, you need to decide whether it makes sense to structure the business as a C corporation rather than as an S corporation, limited liability company (LLC) or partnership. 3 Equal to a 20% tax on long-term capital gains and a 3.8% surtax on net investment income.

4 IN SMALL BUSINESSES // 4 In order to qualify for the QSBS exclusion, a small business must be a C corporation. However, the choice of business entity has tax implications beyond this exclusion, and another legal business structure may ultimately be more advantageous. Having a solid understanding of the tax implications of various options can help you make an informed decision. Similarly, if you re selling a business, you ll want to know whether the QSBS exclusion may apply so you can plan accordingly. In addition, before planning a stock redemption for your company, you may want to consider the potential impact on the exclusion. If a qualified small business redeems stock within certain time periods, both current shareholders and all future investors may be disqualified from claiming the QSBS exclusion. The tax rules and implications surrounding your business s structure, qualification status and stock redemptions can be detailed and complex. Furthermore, although federal taxes typically overshadow state taxes in a sale, the QSBS exclusion is one situation in which state taxes may exceed federal. 4 Talk to your financial and tax professionals to ensure you understand all of your options and the potential impacts on your business and financial picture. REAL-WORLD EXAMPLE: DO THESE INVESTMENTS QUALIFY FOR THE QSBS EXCLUSION? In December 2010, Sally started a small business that manufactures medical devices, forming a C corporation. She invested $100,000 for a 100% interest in the company. The business grew quickly but needed additional investment to keep up with the growth, so in mid-2011, Sally s brother, Bill, invested $200,000 for a 20% interest in the company. At the same time, Sally also wanted to reward her first employee, Paul, for the early success of the company. She granted him stock options in the corporation worth 5% of the company, vesting after three years. The company s rapid growth continued. Needing a large influx of investments to expand operations, the corporation agreed to a round of funding with a venture capital firm (structured as an LLC) for $2 million in exchange for a 40% interest in the corporation on January 1, This round of funding diluted Sally, Bill and Paul s options to 45%, 12%, and 3%, respectively. In 2014, Paul exercised his options and left the company. The shares he received as a result of exercising those options were valued at $300,000. Fast forward to February 2017: Merger, Inc. offered $40 million to acquire the small business Sally started. If the sale goes through, what tax savings would each party receive if the corporation s stock qualifies for the QSBS exclusion? 5 4 Certain states follow the federal tax treatment of QSBS, but others may have a different set of rules. For instance, California offered preferential tax treatment for QSBS in the past, but eliminated the benefit for tax years after Assume that the company was a C corporation engaged in the active conduct of a qualified business with aggregate gross assets less than $50 million at all times, so that the company s stock meets the requirements for the QSBS exclusion. Additionally, all numbers are estimates based on maximum federal tax rates, including the 3.8% surtax on net investment income and are used only for illustrative purposes.

5 IN SMALL BUSINESSES // 5 Date Stock Acquired Initial Investment Ownership in 2017 Gain (After $40M Purchase) Tax Without QSBS Exclusion Tax With QSBS Exclusion QSBS Exclusion Tax Savings Sally (Founder) 12/1/10 $100,000 45% $17.9M $4.26M $1.88M $2.38M Bill (Investor) 6/1/11 $200,000 12% $4.6M $1.095M $0 $1.095M Venture Capital Firm 1/1/12 $2M 40% $14M $3.332M $0 $3.332M Paul (Employee) Options Were Exercised 6/1/14 $300,000 3% $900,000 $214,200 $214,200 $900,000 Results Each of the investors received their stock after September 28, Therefore, each would be entitled to the 100% capital gains tax exclusion, capped at the greater of $10 million or 10 times their basis in the stock. Sally held her shares for more than five years and stands to realize a taxable gain of $17.9 million. However, because of the limitation, she will only be able to claim the QSBS exclusion for $10 million of the gains and will owe capital gains taxes on the remaining $7.9 million. Her tax savings from the QSBS exclusion would be $2.38 million. Bill has also held his shares for longer than the required five-year time frame. His $4.6 million gain is less than the greater of $10 million or 10 times his basis, so he is eligible to claim the exclusion for the entire amount. He would save $1.095 million in taxes as a result of the QSBS exclusion. Paul received stock options in 2011, but didn t receive the stock until he exercised those options in Therefore, his holding period did not begin until 2014 and he would not meet the five-year holding period requirement by the time of the sale. His entire gain would be subject to capital gains taxes. Finally, the venture capital firm owned its shares for more than five years. Although the venture capital firm stands to realize a taxable gain of $14 million, that amount is less than 10 times its $2 million basis in the company. Because the exclusion cap is the greater of $10 million or 10 times the investor s basis, the venture capital firm can claim the entire amount under the QSBS exclusion and save $3.332 million in taxes on its investment. ENHANCE THE EXCLUSION S IMPACT THROUGH GIFTING The QSBS exclusion can be a valuable benefit and incentive for small business owners and investors. However, the many requirements and the cap on eligible gains mean it can be limiting for some investments. Gifting or transferring QSBS may help maximize the impact of the incentive in certain circumstances. Multiply the Excludable Amount Remember that an investor must receive the QSBS directly from the issuing company. This requirement, however, does not apply to QSBS received as a result of a gift or inheritance. The recipient of a gift of QSBS is treated as having received and held the QSBS in the same manner as the donor, and for the same time period as the donor.

6 IN SMALL BUSINESSES // 6 Therefore, if an investor gifts QSBS to multiple beneficiaries (which might include non-grantor trusts), each recipient should be able to separately qualify for the QSBS exclusion and have a separate cap on the maximum gain excluded. While the donor would be liable for any gift tax, he or she may be able to dramatically increase the impact of the QSBS exclusion by gifting the stock prior to it having much value, or by gifting less than the donor s remaining federal estate tax exemption amount ($5.49 million in 2017). Planning With Trusts An investor may want to consider gifting QSBS to an irrevocable non-grantor trust in order to use his or her federal estate tax exemption and remove assets from the estate. The QSBS has the same characteristics in the recipient s hands as it had in the donor s, including the basis in the stock. The gift will not be eligible for the step-up in cost basis at the donor s death if it is transferred into a trust during his or her lifetime. However, the QSBS exclusion may make up for the loss of the step-up in basis. As a result, it may make sense to consider using QSBS for lifetime gifting and transfers. Doing so can remove future appreciation from an investor s estate while still providing favorable tax treatment. The example below illustrates the benefit an investor may receive by gifting QSBS to four irrevocable non-grantor trusts soon after forming the business, when the stock was valued at a minimal amount. 6 Sale Price Basis Gain QSBS Exclusion Exemption Capital Gains Tax Investor Owns all QSBS QSBS Split Among 4 Trusts $40M $1 $40M $10M $7.14M $40M $1 $40M $40M $0 The Importance of Coordinated Planning Proactive estate and tax planning is essential for high net worth individuals, business owners and investors and coordinating all of your planning is just as important. As mentioned previously, the general rule to qualify for the QSBS exclusion states that the stock owners must have received the stock directly from the company (or via gift/inheritance). For example, transferring QSBS to a family limited partnership or LLC has many advantages from an investment and estate planning perspective, but may prohibit you from claiming the QSBS exclusion later potentially eliminating any tax benefit you may have received from the prior planning. LEARN HOW THE QSBS EXCLUSION CAN BENEFIT YOU The QSBS exclusion is an extremely valuable incentive that can benefit entrepreneurs, investors and employees. Prior to starting a business, investing in a company or selling stock, there are many factors and requirements to consider. We recommend working closely with your financial and tax professionals to understand this exclusion, determine if it is right for you and discover how you can make the most of it. 6 Assume that all requirements of the QSBS exclusion are met. Additionally, all numbers are estimates based on maximum federal tax rates, including the 3.8% surtax on net investment income and are used only for illustrative purposes.

7 IN SMALL BUSINESSES // 7 ABOUT THE AUTHORS John T. Welsh Vice President, Wealth Strategy, BNY Mellon Wealth Management John T. Welsh is a wealth strategist with BNY Mellon Wealth Management. As a wealth strategist, John provides comprehensive wealth and estate planning advice to address the unique financial needs of wealthy individuals, families and private business owners. This includes developing innovative strategies in wealth transfer in philanthropy, cross-border planning, analytics and ownership structures to maximize clients global wealth after taxes and across generations. He has over 10 years of wealth and tax planning experience. Most recently, he was with a large international law firm, where he was a part of the private client group providing wealth and estate planning services to ultra-high net worth individuals, families, family offices and foundations. Prior to that, John spent five years as a tax consultant with a Big Five accounting firm and a consulting firm in Chicago. John enjoys spending time with his wife, Katie, and their two children, Grace and Jack. Pamela Lucina Managing Director, BNY Mellon Wealth Management Pamela Lucina is a managing director for BNY Mellon Wealth Management. In this role, she leads a team of wealth strategists offering advice and analytics globally. The Global Wealth Strategist group consists of partner level experts in governance, tax, trusts, estates and international transactions. They work to develop innovative strategies in wealth transfer in philanthropy, cross-border planning, analytics and ownership structures to maximize our global clients wealth after taxes and across generations. Pamela has 20 years of experience providing comprehensive wealth planning advice and governance to individuals and families. Most recently, she was with JPMorgan, where her key responsibilities included providing wealth and estate planning services to the firm s largest and most complex clients, and advising families on next generation education and philanthropic matters. Prior to joining JPMorgan, Pamela spent 10 years in private practice, both as a tax consultant with Arthur Andersen and in the trust and estates department of Mayer Brown in Chicago. She is a Fellow of the American College of Trust and Estate Counsel (ACTEC), is well published, and is a frequent speaker at industry conferences and events. Pamela received a bachelor s degree from Marquette University and a juris doctor from DePaul University. She serves on the board of the Chicago Estate Planning Council (CEPC), and the planned giving boards of the Steppenwolf Theater, Hadley School for the Blind and the Shedd Aquarium. In addition, she is on the board of directors of Girls on the Run. She has been quoted in numerous business publications including Dow Jones, Forbes and Trust & Estate magazine.

8 IN SMALL BUSINESSES // 8 Justin T. Miller Senior Director, BNY Mellon Wealth Management As a senior director at BNY Mellon, Justin Miller works collaboratively with other advisors to provide comprehensive wealth planning advice to clients and their families. Prior to joining BNY Mellon, Justin was a senior vice president and managing director at a large national bank, where he led a wealth management team that was dedicated to addressing the unique financial needs of wealthy families, senior corporate executives and closely held business owners. Before that, he was an attorney at a major law firm, where he advised high net worth clients regarding tax-efficient estate and business succession planning, trust law and management and asset preservation. Justin is a sought-after speaker on tax, estate planning and family governance topics at conferences throughout the country, including events hosted by the ABA, ACTEC, CalCPA, Golden Gate University, Santa Clara University, Silicon Valley Community Foundation, Stanford University, the State Bar of California, UCLA, Vistage International and YPO. He also has published numerous articles, and has been quoted as an industry expert in a variety of publications, such as The Wall Street Journal, the ABA Journal, The Recorder, the Daily Journal, the Chicago Lawyer and the New York Law Journal. In addition, Justin is an adjunct professor at Golden Gate University School of Law, an executive committee member of the State Bar of California Taxation Section and the editor-in-chief of the California Tax Lawyer. Justin received a master of laws in taxation and a juris doctor from New York University School of Law and a bachelor s degree, with honors, from the University of California at Berkeley.

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