To strengthen the fundamentals of a company and build wealth, I was taught decades ago in business school to pay only secondary attention to tax laws. In other words, do not get distracted by trying to make the tail wag the dog. Tax incentives and special deductions come and go, so it’s generally not a good idea to structure a company primarily to gain ephemeral tax sugar highs.
The American Taxpayer Relief Act of 2012 with its new Section 1202 provisions to exempt capital gains taxes on qualified C corporation business investments made in 2013 has turned my head this year. This new law may be an exception to the rule where a traditional corporate structure, a C corporation, may indeed have significant benefits for small business owners and investors under certain circumstances.
I advise small business owners to form their companies as pass-through entities such as limited liability companies and S corporations where there is no corporate tax or personal liability. Typically, the reason to form a taxable C corporation is to be prepared for a public offering, which is not in most small business owner’s minds. However, creating wealth in a business that is to be harvested tax-free as part of an investor or owner exit strategy is of high interest to small business owners.
Many of my small business clients have revenue under $5 million annually. These types of companies often have the opportunity to double their sales volume over the next five years if only they had proper guidance and the financial resources for an expansion. It is hard to save up to self-finance these expansions when clients owning LLC or S corporations are taxed nearly 40 percent on their profits.
A client with a C corporation, on the other hand, could avoid this tax situation altogether by reinvesting profit back in the business. However, eventually when the company is sold or dividends paid to the owners, there will be taxes owed of up to 20 percent on the capital gains.
Here is scenario where Section 1202 can help build wealth for a company and its owners if they take action in 2013. Your current business is a non-C corporate small business poised to grow and be profitable. With an injection of investment in 2013 and continued reinvestment of profits your business can boost itself to the next level, perhaps doubling its revenue in 5 years. So you decide to convert your company into a C corporation, offer equity to investors and have a plan to reinvest profits to avoid tax and build capital in the business.
After the five-year holding period, you can begin to sell equity created by your 2013 investments in the business with no taxes payable up to $10MM, or 10 times your original investment. There are certain qualifications and restrictions associated with Section 1202 use, so a careful analysis of its applicability to your business is important before taking any action.
For many business owners and investors, issuing shares in a new C corporation in 2013 for purposes of taking on new investment, especially combined with a reinvestment of profits plan, makes sense and can create significant tax-free income.
Business consultant Harley Luplow of Harbor Springs earned a law degree from Indiana University and a master’s in business administration from Georgetown University. Luplow can be reached at 709-9000 or email@example.com.