Here’s how you could pay zero federal tax on gains from small business stock

For small business owners, company revenue and personal income are one in the same. It makes sense, then, that entrepreneurs would feel strongly about taxes. According to our research, paying more taxes is top of the list of things small business owners cannot abide.

Guess what? Thanks to a little piece of legislation called the Protecting Americans from Tax Hikes (PATH) Act, passed in December 2015, some small business owners can enjoy a major tax break on any gains from the sale of company stock. In fact, in some cases all of the gain can be exempted from federal tax!

Of course, there are stipulations. Here’s the list of criteria to for qualified small business stock (QSBS) under Section 1202 of the Internal Revenue Service code:

  • The stock must be issued after August 10, 1993.
  • You must own the stock for at least five years.
  • The stock must be in a domestic C corporation. Sorry! S corporations, LLCs, etc. don’t qualify.
  • The company must be a C corporation for “substantially” all of the time of stock ownership.
  • The company can’t have more than $50 million in assets at or near the time the stock is issued.
  • You have to acquire the stock directly from the company (not from a secondary market) for cash, property (other than stock), or services.
  • While you own the stock, at least 80% of the value of the company’s assets must be used in the “active conduct” of one or more qualified business. (In other words, it has to be an active business, not a shell company.)

Does your stock check all the boxes so far? Good! But don’t get ahead of yourself; there’s more. Companies in certain industries are excluded from consideration for QSBS benefits. According to Wealthfront, these are:

  • A service business in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
  • A banking, insurance, financing, leasing, investing, or similar business
  • A farming business
  • A mining or natural resources business
  • A business involving the production of products for which percentage depletion can be claimed
  • A business of operating a hotel, motel, restaurant, or similar business

Still checking all the boxes? Cool. Now, let’s show you how your QSBS tax benefits might play out.

Capital gains from the sale of QSBS up to $10 million or 10x your tax basis — whichever is higher — are eligible for up to 100% reduction in federal taxes (note that state tax laws vary considerably).

That means if you had a $5 million interest in a qualifying small business in 2013 and wanted to sell it next year, you could collect a tax-free gain on the $50 million sale. Let’s say your interest was $100,00, not $5 million, but you sold for $10 million. All things equal, you’d still collect a tax-free gain.

Want more detail? Here’s a scenario from the smart folks at Wealthfront:

Of course, things are never cut and dried when taxes are involved. Read deeper into this Wealthfront post to see how alternative minimum tax (AMT) throws some wrenches into things. Then, take a look at this super helpful post from Andersen Tax for more specifics, and a QSBS calculator to see how much of your gains are eligible for tax exclusion.

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