Potential Tax Benefits for Small Businesses Under New Law
A recent legislative change, known as the One Big Beautiful Bill Act, could offer significant financial advantages for small business owners looking to sell in the near future. Signed into law by President Trump in July, this bill expands the benefits associated with qualified small business stocks (QSBS) under specific capital gains tax rules.
More businesses may now convert to C corporations, which could be particularly beneficial for newly established AI startups eager to develop exit strategies. However, this change isn’t only relevant to tech companies; entrepreneurs in various sectors planning to sell could see notable tax savings.
Of course, engaging with the QSBS planning process can be complicated, with various eligibility requirements to consider. Data from the Exit Planning Institute suggests that older business owners are especially inclined to sell, with 58% of baby boomers indicating plans to do so in the next five years. This is contrasted by 39% of Generation X and 48% of Millennials who are contemplating similar moves. Yet, regardless of age, exit planning appears to be a primary concern for entrepreneurs across the board.
Key Changes Created by the New Legislation
So, what do the new regulations entail? The law raises the tax-free profit limit for eligible C corporations that issue stock after July 4, increasing it from $10 million to $15 million. Additionally, the required holding period for shares has been shortened from five years to three, and partial tax incentives for owners who sell after three or four years have been introduced. This change may shift the strategy for companies wanting to sell sooner than before, making QSBS more appealing.
Moreover, the asset limit has been increased from $50 million to $75 million, making more small and medium-sized businesses eligible for these benefits. Adjustments for inflation are also included in the law.
Understanding Corporate Structures
Now, let’s talk about what small businesses need to consider regarding these favorable changes. To qualify, a company must be structured as a C corporation, a detail that many entrepreneurs might overlook. Corey Pederson, a wealth strategist based in Salt Lake City, notes that prior to recent tax reforms, being a C corporation wasn’t always advantageous for small businesses. As a result, many operate as sole proprietorships or partnerships, which often incur self-employment and individual taxes. While S corporations are another option that can help avoid double taxation by passing profits directly to owners, the new changes could encourage more businesses to opt for C corp status.
Faster Sales with New Reforms
Typically, U.S. taxpayers are required to pay federal capital gains tax upon selling their company’s stock for a profit. However, qualified small business stock can provide substantial tax benefits, allowing entrepreneurs and investors to exclude or defer these taxes with proper planning. By converting to a C corp, many small businesses could potentially capitalize on millions in QSBS tax benefits in the coming years.
Previously, shareholders had to hold shares for five years to enjoy these tax benefits. The updated law permits a more gradual approach: after three years, owners can access 50% of the tax benefits, 75% after four years, and 100% after five, which might appeal to many. This phasing offers a more attractive option for business owners.
Addressing Double Taxation
However, one notable disadvantage of a C corporation is its double taxation structure, where profits are taxed at both the corporate level and again when distributed to shareholders as dividends. Consulting with a tax professional may offer solutions to mitigate this issue. For those who have run small businesses for a decade or two, the recommendation is to retain profits within the company while using personal savings for expenses. As Pederson points out, without sufficient savings to cover costs, this tactic may not be feasible.
According to U.S. Census Bureau data, it’s expected that by 2023, two million small businesses will have organized as corporations. Many of these could reap additional savings under the new tax law. It’s crucial for older business owners to evaluate their situation, especially since a significant number have expressed they aren’t ready for a formal evaluation or succession plan.
In conclusion, even if the idea of converting to a C corp was previously dismissed, it may be time to reconsider. Natalie Welton, a senior wealth advisor at HB Wealth in Atlanta, notes that the increased eligibility limit allows many more businesses to explore this option.
