Tax increases are coming; in fact, they are already in effect, assuming they are approved as proposed. The “already cash” rule is designed to prevent the sale from getting below the wire. Whether that strategy will work depends on how good your crystal ball is. Make no mistake, these tax increases have a huge impact. The Biden administration’s so-called “Green Book” has nothing to do with the environment, and everything to do with tax increases. The General Explanations of Management’s Revenue Proposals for Fiscal Year 2022 they are not mere adjustments to the tax code. Right now, there is a top tax rate of 37 percent. You don’t reach that rate until (as a married couple) you have more than $ 628,300 in taxable income. Biden’s proposal would raise the top marginal rate to 39.6 percent as of December 31, 2021 for couples with more than $ 509,300 in taxable income. Capital gains increases are more ambitious. Instead of top rates of 20% plus the 3.8% Obamacare tax, you completely lose capital gain rates if you make more than $ 1 million. Now you will pay 39.6% more the 3.8% Obamacare tax, down a whopping 43.4%. And here’s the kicker: that capital gains tax hike is already in effect, retroactively to the date that Biden first announced his proposal to Congress on April 28, 2021.
Is there any good news in this? The qualifying small business stock supply that has been a darling of the tech industry for decades is set to be quietly put down. You can get up to $ 10 million tax-free that way, or in some cases possibly even more if you can creatively take advantage of the limit with the family. But be careful, that can backfire too. Among other requirements, the $ 10 million QSBS allocation is only for selling certain shares in a C corporation. You can read about the qualifications for the $ 10M tax-free or tax-deferred. Of course, choosing the entity for small and not-so-small businesses involves a lot of tradeoffs, and not all businesses are the same. Traditional options are corporations, associations Y limited liability companies (LLC), but you have to think ahead.
A few decades ago, when an individual left ownership behind, a corporation was almost always the logical choice. In more recent decades, LLCs have become the new norm. They are generally taxed as partnerships. That means the partners (or using LLC terminology, ‘members’) pay taxes on the business income themselves on their own self tax rates. Continuous flow tax treatment continues to be favored. In fact, entities like partnerships, LLCs, and S corporations got a big boost from Trump’s strategy. Jobs and Tax Cuts Act, Provision 11011 Section 199A. But so did corporations when the corporate tax rate was slashed from 35% to 21%, also by Trump. Biden wants the corporate rate to rise to 28%, but it could settle in the middle. Even at 28%, the C corporation rate is lower than the rate that S corporation or LLC owners will pay on their transfer income.
But the problem is in the two levels of taxes that C corporations and their shareholders are subject to. After all, the income of a C corporation is taxed twice. The corporation pays taxes on its net income. Then shareholders also pay taxes on the dividend distributions they receive. In contrast, the income of an S corporation is taxed once at the shareholder level. Starting in 2018, the tax law radically reduced the corporate tax rate paid by C corporations from 35% to 21%. That means the C corporation status is much better, right? Well, compare that 21% rate to the way an S corporation is taxed. Individual tax rates were also lowered. The maximum rate was reduced from 39.6% to 37%. Then there is the transfer deduction. If you qualify, you can lower the maximum effective tax rate from 37% to 29.6%. To many, the idea of a 29.6% tax rate sounds pretty good, even compared to the 21% C corporate tax rate.
With a C corporation, taxes at the shareholder level must also be considered. Dividends are generally taxed at 15% or 20%, depending on income levels. Taking corporate tax and shareholder tax into account, unless you leave all income in the corporation, you will end up paying more taxes with a C corporation, even at the 21% corporate rate. What can a $ 10 million problem be? And that brings us to the magical Small Business Qualified Stock (QSBS) benefit that Biden keeps in place. It only applies to the shares of corporation C.
For qualifying small businesses, typically up to $ 50 million in assets, shareholders who have held their shares for 5 years can exclude their earnings from federal taxes. The shareholder limit is generally $ 10 million, and $ 10 million tax-free would be nice! If you sell QSBS but haven’t held it for 5 years, there is another benefit from QSBS. You can defer the profit by transferring it to a new investment in QSBS. All in all, the QSBS rules can allow founders and other shareholders huge tax-deferred or tax-free Benefits.
S corporation shares do not qualify as QSBS, and an S corporation cannot have more than 100 shareholders, only US citizens and resident aliens as shareholders. The shareholders generally must be individuals (and certain limited types of trusts), and the corporation generally must have a calendar year. If there are several classes of shares, only differences in voting rights are allowed. For most small businesses, these criteria are easy to meet. If the owners are more comfortable with the corporate form than with an LLC, an S corporation may be a good option. However, the accounting rules for S corporations are more complicated. Also, the conversion from C to S can be nuanced. An S corporation may face corporate taxes if it was previously a C corporation and elected S status in the last 5 years (the income tax incorporated).
Choosing what type of business entity and then developing your tax options clearly involves some tough decisions. It’s even harder to plan when tax laws seem to be always changing. However, the presence of the rated small business stock rules as what could be a permanent feature of the tax law makes C corporations worth another look, even if it seems likely that the tax rate will increase by 21%. If you have a high income and are a founder, the benefits of QSBS can be hard to ignore.