New 50% exclusion for gain from QSB stock.

• Author: Luchs, Lorin D.
• Position: Qualified small business

The new tax benefit provided by Sec. 1202 appears to be helpful to an existing C corporation that meets the requirements of a qualified small business (QSB) (as defined in Sec. 1202(d)) and desires to raise additional equity capital. It also may be useful to an existing sole proprietorship or partnership that is considering incorporating to raise equity capital. However, the use of an S corporation (which cannot be a QSB) may be more advantageous. While, unlike an S corporation, a QSB has no limit on the number of shareholders, its gross assets, measured by aggregate adjusted bases, both before and immediately after the stock issuance cannot exceed $50 million.

Profitable corporations

This 50% gain exclusion does not appear to change the tax advantages of an S corporation over a C corporation (even after the increase in the top individual rate), although it minimizes the difference. A top individual rate of 36% or 39.6% on taxable income of an S corporation is still lower than a combined corporate/individual tax of 43.24% (34% corporate tax + 9.24% [14% x 66%] individual tax) on a QSB's income (ignoring the possible 35% corporate regular tax bracket and the alternative minimum tax). However, the advantage of the lower tax rate on S income, besides other S corporation benefits, must be weighed against the time value of money benefit to a C corporation taxed at 34% (or, possibly, 35%) versus 36% or 39.6%, for at least five years (the minimum required holding period of QSB stock).

In addition, a C corporation may be more advantageous than an S corporation if corporate income will be retained (instead of distributed to the shareholders) and a sale of the corporation's stock is not contemplated until after all (or a substantial portion) of the stock will obtain a stepped-up basis due to a shareholder's(s') death(s). On the other hand, an S corporation may be desirable if the corporation's stock will be sold during the shareholder's(s') lifetime(s) because the corporation's income that is taxed to the shareholder also increases the stock's basis.

Of course, state income tax consequences also must be considered.

Start-up corporations

It may be more beneficial for a new business anticipating startup losses to be an S corporation. The ability of the shareholders to currently deduct initial years' losses may be more beneficial than a 50% exclusion on possible later gain. However, QSB stock may qualify as Sec. 1244 stock to the extent of the Sec. 1244...