Alert 01.23.24
Alert
Alert
02.06.24
Most business owners and founders are aware of the basic forms of corporate structure, such as C corporations, S corporations, limited liability companies and limited or general partnerships. However, too often, their related decision-making ignores alternatives that may offer similar protections but greater advantages, or that supplement these core structures. Discussed in this article are the basics of qualified small business stock and various other tax incentives targeted at encouraging research and development.
Qualified Small Business Stock
Under Internal Revenue Code (IRC) Section 1202, certain gains on stock that meet the definition of qualified small business stock (QSBS) are excluded from tax when sold if certain conditions are met. This provision became permanent with the passage of the Protecting Americans from Tax Hikes (PATH) Act on December 18, 2015. If stock qualifies, part or all of the total gain on the sale of the stock is excluded from federal tax, depending on when the initial stock investment was made.
If the stock was acquired before February 18, 2009, the exclusion is 50 percent; if between February 18, 2009, and September 27, 2010, the exclusion is 75 percent; and if acquired thereafter, the exclusion is 100 percent. In application, this means that only 50 percent, 25 percent and zero percent of the respective sales proceeds will be subject to tax, with the remaining amount being tax free. If only a partial exclusion applies, the capital gain rate that applies to the non-excluded percentage is 28 percent, assuming that the taxpayer is in the 15 or 20 percent bracket for long term capital gains. A per-issuer limitation on eligible gain does exist, limiting the aggregate amount of eligible gain under Section 1202 to $10 million or 10 times the aggregate bases during the taxable year.
To qualify as QSBS, the corporation must be a domestic C corporation (not an S corporation or LLC) and it must have been a C corporation for substantially all of the time that the shares were held. An LLC can convert or otherwise become a C corporation with stock issued at that time potentially qualifying if the fair market value of the company assets at the time is not over $50 million and the company otherwise qualifies. The corporation can’t have over $50 million in assets when the stock is initially issued or immediately thereafter (different from the $50 million fair market value requirement at a conversion or other LLC to C corporation transaction). The stock must have been acquired at its original issue from the issuing company and not on the secondary market.
Certain redemption transactions that take place shortly before or after an issuance of new stock can remove the QSBS status of the newly issued stock. The redemption transactions are tested over a two-year period at the individual shareholder level and a one-year period at the corporation level. As a general rule of thumb, de minimis redemptions, or redemptions where the amount paid is less than $10,000, will not negate the original issuance requirement. Also, during substantially all of the time the stock was held, at least 80 percent of the corporation’s assets must have been used in the active conduct of a qualified business.
The active business definition excludes a number of business types from the benefits of Section 1202. Investment vehicles, banking, insurance, financing and leasing are not active businesses. Service businesses are excluded and are defined to include health services, law, engineering, architecture, accounting, actuarial science, performing arts, athletics, financial services, brokerage services, consulting, and any other business where the principal asset of the business is the skill or reputation of one or more of its employees. Farming is excluded, as well as any business that produces a product subject to percentage depletion. Finally, operating a hotel or restaurant does not constitute an active business.
Additionally, the stock must have been held for five years prior to sale for Section 1202 to apply. Interestingly, should the company be bought by another company before the five-year holding period has passed, the shares might still qualify for the Section 1202 exclusion. If the acquirer uses its own stock in exchange for the stock of the target company, then the resulting shares of the acquirer could become QSBS shares to the extent of gain as of the date of the transaction. Only the gain that occurs after the transaction date would be taxed under the normal rules. Gains can also be rolled over from one QSBS to another under Section 1045. To qualify under Section 1045, the QSBS must have been held for more than six months and the sales proceeds must be invested in another QSBS within 60 days of the first sale.
State tax and the alternative minimum tax (AMT) for individuals still apply to gains on the sale of QSBS. California formerly offered preferential tax treatment for QSBS but ended the preference for tax years following 2012.
The Section 1202 federal exclusion applies to both investors and company employees, as long as the requisite conditions are met. Thus, angel investors and some venture capital investors benefit from the provision. However, the holder of the stock must be an individual and not a corporation. This structure is popular in the venture capital infrastructure, where LLCs and partnerships have yet to gain a foothold. Traditionally, such investors aimed for an initial public offering (IPO) of their portfolio companies, for which a C corporation structure was required. Even as IPOs have been partially replaced by acquisitions for a variety of reasons, many companies and investors still favor the C corporation structure and benefits of Section 1202. And for companies on this path, the Section 1202 option is a powerful incentive.
Clients should be advised to document any potential QSBS investments carefully. As some small or startup companies don’t always keep meticulous records, documenting a path later might not be possible. Especially important is documenting that the company had less than $50 million in assets immediately after the initial purchase and that at least 80 percent of the assets were used in the active conduct of a qualifying business. Clients should also get a stock certificate issued to them and keep a copy of the cancelled check or other documentation showing the initial investment.
Tax Benefits Available to Startup Businesses
The Internal Revenue Code offers certain tax benefits and incentives that can be especially helpful to taxpayers during the early years of trying to get a new business off the ground and turning a profit. These provisions include incentives targeted at encouraging development of innovative new products, intellectual property and other intangibles.
One such incentive provision applies to research and experimentation expenditures paid or incurred by a taxpayer in connection with the taxpayer’s trade or business. Under Section 174 of the IRC, taxpayers have the option of electing to treat qualifying research and experimentation expenditures as currently deductible expenses. When such expenses are taken as a current deduction, there is no recapture upon the subsequent sale of the resulting technology. Under 2017’s Tax Cuts and Jobs Act (the JobsAct), effective for amounts paid or incurred beginning after December 31, 2021, specified research or experimental expenditures are capitalized and amortized over a five-year period. This time for capitalization and amortization is 15 years if the research is done outside the United States. This capitalization and amortization requirement applies for certain types of activities, including software development. Additionally, under the Jobs Act, the application of this provision is treated as a change in the taxpayer’s method of accounting under IRC Section 481, but no adjustment is made for research or experimental expenditures made before January 1, 2022.
For purposes of Section 174, research and experimentation expenditures are defined as “research and development costs in the experimental or laboratory sense,” generally including all such costs incident to the development or improvement of a product. For example, attorneys’ fees incurred in obtaining a patent are considered research and experimentation expenditures. The regulations under Section 174 explain that expenditures represent research and development costs in the experimental or laboratory sense if they are for “activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.” Uncertainty is considered to exist if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
There still exists a lot of uncertainty concerning the implementation of Section 174 with respect to contract research arrangements. In recent guidance, the IRS provided “if a research provider that does not bear financial risk under the terms of the contract with the research recipient obtains an ‘excluded [specified research or experimental expenditures] SRE product right’ … but does not obtain any other SRE product right under the terms of such contract, then the costs paid or incurred by the research provider to perform SRE activities on behalf of the research recipient under such contract are not SRE expenditures.” SRE expenditures are specified research or experimental expenditures and are a new term introduced in IRS Notice 2023-6. The IRS is expected to release proposed regulations addressing this issue and several others soon. The recently proposed Tax Relief for American Families and Workers Act of 2024 includes proposed changes to the rules under this tax code section.
The IRC also offers business tax credits for certain research activities, which can be used by companies incurring research and development costs. Designed to encourage research, the research tax credit under Section 41 is a nonrefundable credit for a percentage of qualified research expenses. These expenses generally must be paid or incurred “in carrying on” an established trade or business of the taxpayer; however, there is an exception to this requirement that allows in-house research expenses of a startup to qualify if the principal purpose of the expenditures is to use the results of the research in the active conduct of a future trade or business.
The credit is available for qualifying research activities related to the development or improvement of a business component. For purposes of this discussion, the definition of “qualified research” can be distilled into a four-part test:
If these conditions are met, then the business generally qualifies for a research and development credit. The regulations elaborate on this oversimplification and provide concrete examples. Wages, supplies, contract research and basic research payments qualify for the credit. These credits can be carried forward 20 years and back one year. The Inflation Reduction Act increased the credit amount to $500,000 for qualified expenditures incurred in taxable years beginning after December 31, 2022.
Net operating losses (NOLs) can also be utilized to save taxes on income earned after the development stage of a company. NOLs are loss amounts incurred by companies during their unprofitable years that can be deducted against future and past earnings to lower taxes paid in profitable years. Under the Tax Cuts and Jobs Act, these losses can be carried forward indefinitely, but can no longer be carried back. The Act also allows 100 percent first year expensing of certain depreciable assets placed in service after September 27, 2017, and before January 1, 2026.
Conclusion
When starting a new business, it is critical for business owners to find the right corporate and tax structure to build their business for the long term. Too often, advisors look only to obvious answers and ignore more complex provisions in the IRC that may offer business owners options better tailored to their distinct needs, as well as financial incentives to assist them in getting their business off the ground. When starting or running a business, every penny can make a difference. Time not spent on planning may also lead to excessive tax or litigation costs down the road. Subtle planning differences can magnify the benefits greatly when revenues become meaningful.