Congress is encouraging you to engage in “start-up” businesses that have huge upward growth potential, whether it be in high-tech endeavors or research and development activities. Even industries that perhaps Congress did not intend to encourage, such as a business involved in the cannabis growth, manufacture or retail industries, can benefit from the trending use of Tax Code Section 1202.
The tax incentive is as follows: If you operate a small active business in a C corporation (or in a business that you convert to a C corporation) for five years, you can then sell the stock in that business for huge capital gains without paying a dime in capital gain taxes. These C corporations in the meantime are subject to a tax rate of only 21%, and if you can hold off on making any dividend distributions to yourself, then you can avoid any “double taxation” that is usually associated with C corporations. Unlike a number of individual income tax provisions that were newly enacted and implemented last year, this 21% tax rate does not sunset after 2026. This preferential rate is therefore considered a “permanent” favorable tax law provision.
Because of Tax Code Section 1202, you should consider taking advantage of (if you have not already) issuing stock to yourself and operating your business as a C corporation for at least a five-year period so you can benefit from this generous capital gain exclusion opportunity when you sell the business for a profit. The Tax Code allows, at a minimum, the total avoidance of $10 million in taxable capital gains on sales of interests in the business. As such, there is no capital gain tax, no 3.8% net investment income tax, and no alternative minimum tax, with respect to the excluded capital gains.
If you have already begun an active trade or business, but are operating that business as a flow through entity such as a partnership, LLC, or even as a sole proprietorship, this may be the time to convert that business to a C corporation to get the five-year clock ticking. There are also provisions that allow for gifts of such businesses to certain trusts without interrupting the five-year seasoning period of this planning opportunity.