Previously, I discuss issues related to structuring ownership. This post is a happy topic – what to do with the profits from your business. A business can either distribute current earnings to its owners or accumulate and reinvest earnings with the goal of growing the business so it can in the future be taken public or sold for cash or the marketable stock of a purchaser. Current earnings are taxed as ordinary income whereas the gain on the sale of stock held more than one year is taxed at the more favorable long term capital gain rates.
Consider a Tax Flow Through Entity
If the business intends to distribute current earnings, a tax flow through entity, like a partnership, LLC or S-Corp, is likely the best choice because the earnings can be distributed without incurring a second level of tax. If the company, however, is a C-Corp, earnings can be distributed without incurring a second level of tax only if they are paid as salary or other reasonable compensation to shareholders who work for the business. This compensation is deductible by the corporation against its taxable income. Other distributions of earnings by a corporation to its shareholders, other than compensation, will be taxed as dividend income to the shareholders. It is not deductible by the corporation. Most small companies that distribute the business’ current earnings, and don’t have owners who work for the company have a strong incentive to use a tax flow through entity like an S-Corp, partnership or LLC.
Income Tax Incentive for Building Value in Your Business
Federal income tax law provides an additional incentive to organize as a C-Corp for businesses that seek to build long term value rather than distribute current earnings. With a C-Corp (but not any other business entity) that qualifies as a small business corporation, stock issued after August 1993 that is held for at least five years is generally eligible under IRC section 1202 for a reduction of at least 50 percent in the capital gains tax payable upon sale, reducing the effective rate to approximately 14 percent. Recent revisions to the tax code provide a reduction of somewhere between 75 and 100 percent in the capital gain tax rate upon sale through 2012. The tax code is always changing so make sure you contact us about recent changes and how they may affect your business planning.
Section 1045 Can Benefit Non-Corporate Investor
Under IRC section 1045, a non-corporate investor who sells qualified small business stock in a C-Corp can defer any gain recognition on the sale by reinvesting (rolling over) the sale proceeds into a new qualifying small business stock within 60 days of the sale. Under IRC section 1244, an initial investor whose investment complies with the conditions of the statute, and who later realizes a loss on his qualifying small business stock, may treat the loss as ordinary loss rather than a capital loss, taking the potentially greater tax benefits.
For more information on how Finkel Law Group can help you properly structure your new or existing business enterprise to take maximum advantage of state and federal tax laws, call us for a consultation at (415) 252-9600 or visit us as www.finkellawgroup.com. We look forward to talking with you.