The recently-signed Protecting Americans from Tax Hikes Act of 2015 reinstates some expired tax benefits retroactively and makes them permanent. On the list is the 100% tax exclusion of the gain from sales of qualified small business stock (QSBS).

Example 1: Nick Oliver creates a company in 2016 and sells all the stock in it in 2022 for a $3 million gain. If the stock meets the requirements to be QSBS, Nick will owe no tax on that $3 million profit. (In most cases, tax-free gains of QSBS are capped at $10 million.)

The Devilish Detail

A five-year holding period for the stock is required; however, the main obstacle to tax-free gains may be the structure of the business. Among other things, for the 100% exclusion to apply, the QSBS rules require the taxpayer to sell stock in a C corporation that was originally issued after September 27, 2010. Consequently, selling shares of an S corporation or membership units of a limited liability company (LLC) won’t generate tax-free QSBS treatment. 

With that in mind, should entrepreneurs structure their companies as C corporations? Is the lure of potential tax-free gains sufficient to choose this type of entity?

C Corporation Drawbacks

With a C corporation, double taxation can be an issue. 

Example 2: Suppose that Nick Oliver runs his business as a C
corporation; if so, the company’s profits would be exposed to the corporate income tax. Then, if Nick distributes the profits to himself, he’ll owe tax on those dollars at ordinary income rates. Meanwhile, Nick’s company gets no deduction for the dividend payout.

Efforts to avoid this double taxation may lead to problems. Paying the profits to himself as a tax- deductible salary or bonus may bring Nick an IRS penalty for unreasonable compensation, yet retaining the dividends in the company might lead to the accumulated earnings tax.

With an LLC or an S corporation (assuming requirements are met),
there is no corporate income tax and no need for planning around it. The company’s profits are taxed once, on the owners’ personal income tax returns. What’s more, many closely-held companies will report operating losses, especially in the early stages of the business. S corporation and LLC owners may be able to deduct those losses on their personal tax returns, but that opportunity is not available to C corporation shareholders.

Blocked at the Exit

Even if you decide to structure your company as a C corporation, and if a profitable sale of the business becomes a possibility, you still might not be able to enjoy tax-free gains. That’s because QSBS treatment relies upon the sale of stock in the business. However, shares of stock might not change hands when a small company is acquired.

Often, a buyer will prefer to purchase the assets of a company, rather than the shares. Purchasing all of a company’s assets effectively transfers ownership of the business to the buyer.

Taxes play a role in this buyer preference. After an asset purchase, the basis in those assets often can be stepped up to market value, which may provide the new owner with valuable depreciation deductions.

Perhaps more important, buying stock could result in the assumption of unknown liabilities. Environmental issues may surface in the future; claims for prior damages might be filed. Although such concerns may be addressed in a stock purchase agreement, the possibility of future exposure could cause buyers to shy away. In our example, Nick might operate a C corporation for many years, dealing with double taxation, only to eventually exit via an asset sale and lose the QSBS tax exclusion.

Reaching a Decision

Generally, entrepreneurs who intend to hold onto a business for the long run, perhaps passing it on to family members, may be well served with an LLC or S corporation structure. Conversely, those who hope to attract outside investors, grow the business rapidly, and ultimately go public might prefer to run a C corporation. The possibility of tax-free gains can be another factor, tipping the scales towards a C corporation. 

Specific circumstances will vary from one company to another. Our office can help you decide upon a business structure, weighing the chance that you’ll one day be able to take tax-free gains on the sale of qualified small business stock.

The American Taxpayer Relief Act of 2012 changed the federal estate tax rules by significantly increasing the amount that individuals can pass to their beneficiaries tax free. Now that most estates will not incur a federal estate tax liability, there are new opportunities for taxpayers to lower the future income taxes of their intended beneficiaries.

Background

Under current law, an estate may be worth as much as $5.43 million before federal estate taxes will apply. (This exclusion amount increases to $5.45 million in 2016 due to IRS inflation adjustments.) When certain requirements are met, married couples may potentially exclude up to twice this amount from estate tax (e.g., $10.86 million in 2015 or $10.9 million in 2016) by using the tax law’s exclusion “portability” provisions.

Including Assests in an Estate

With such a high exclusion amount, most taxpayers face little risk of incurring federal estate tax liability. Instead of trying to reduce their estates by making lifetime gifts, taxpayers may want to consider keeping selected assets in their estates. This strategy could reduce the capital gains taxes their heirs will owe if they later sell the assets.

How so? Upon sale, capital gains tax will apply to the difference between an asset’s “basis” and the net sale proceeds. “Basis” is generally equal to an asset’s original cost, plus improvements, minus depreciation. However, assets passing through an estate generally receive a stepup in basis to their fair market value on the date of death. For example, securities purchased for $10,000 that are worth $75,000 when the owner dies will have a basis of $75,000 to the person who receives them from the estate. If that person sells the securities for $75,000, no capital gains tax would be due. In contrast, assets transferred as lifetime gifts receive no basis step-up.

Because the value of many assets — such as investments and
houses — tends to increase over long periods, leaving these assets in the estate can substantially reduce the future capital gains tax liability of beneficiaries in the event the assets are subsequently sold.

However, each individual taxpayer’s situation is different, so each gifting strategy should be separately analyzed to determine the best course of action.

Recent Development

To improve consistency in basis reporting, a recently enacted law
requires executors of estates to report the value of estate assets to both the IRS and the person receiving an interest in the property, generally within 30 days after filing the estate tax return for the estate. The new law is applicable for federal estate tax returns filed after July 31, 2015. However, for statements required to be filed with the IRS or furnished to a beneficiary before February 29, 2016, the IRS has delayed the due date of the statements until February 29, 2016.

Please contact us if we can help you with your tax planning or with
preparing basis-reporting statements for an estate.

Data breaches at large companies often make headlines. The good news is that major corporations have the resources (and, increasingly, the motivation) to protect themselves from electronic intruders. If your company does business with firms in the S&P 500, your personal and business data probably are secure.

The bad news? Thwarted hackers and identity thieves may step up attacks on small and medium-sized companies. Such firms often do not have strong defenses in place, so they may be vulnerable.

Consequently, your company’s customer data and banking information may be targets. Dealing with electronic theft can be costly and time consuming—and extremely stressful. If you suffer a data breach and word gets out, damage to your reputation can be severe. Small companies may even be forced out of business as a result.

Putting Protection in Place

To avoid such disasters, you need to recognize the risk and adopt a plan to secure your electronic information. It may be well worth the time and money to bring in a third-party expert to review your cybersecurity and make recommendations.

Often, recommendations include a program of educating your employees about data security, with periodic sessions to inform your staff about new threats. For example, if employees need passwords to access private information, they should avoid using the same password for years, on multiple websites. You might want to investigate using a password manager yourself, for company related matters, and having employees use one as well.

Password managers, found online, store someone’s login information for various websites and allow users automatic entry. The user has just one master password to remember while different, changing passwords are submitted to provide the desired access.

There are also services that can securely transfer sensitive files, if you prefer not to send them as an email attachment.

Protection Points

In addition, your company should take steps to protect against malware: hostile or invasive software that may be used to steal personal information and commit fraud. You can reduce your risk in this area by installing antivirus software and keeping it current. Your company also can implement policies regarding the types of websites and data that employees may access while on a company network.

The U.S. Chamber of Commerce offers suggestions for establishing policies for employees’ acceptable use of electronic devices. Employers might require the following:

• Logging off or applying a screen lock to their computer before leaving it unattended even for a short break.
• Assigning employee responsibility for computer access and equipment taken off-site.
• Limiting employee and family members’ personal use of company computers.
• Limiting the use of personal machines on the company network.
• Establishing employee liability when personal acceptable use has not been followed.