Consider Incorporating to Leverage Capital Gain Exclusion

By Marcia Richards Suelzer, Toolkit Staff Writer

Incorporating your business now may yield a surprising result when you sell it in the future: You won't have to pay tax on gain from the sale!

Back in September 2010, Congress passed a "small business jobs act." In that law, tucked deep in the recesses of the Internal Revenue Code, is a provision designed to spur business growth by providing a tax break for those who invest in small business stock. Right now, an individual can exclude 100 percent of the gain realized from the sale of certain small business stock.

Incorporating your business can help you to avoid capital gains.

Example. You invest $1,000 in Big-Multinational-Corporation (BMC). Five years later you sell your stock for $101,000, which is a gain of $100,000. Assuming a long-term capital gains tax rate of 25 percent, you will owe $25,000 in tax on the sale. However, if you purchase $1,000 worth of shares in Mom-n-Pop, Inc. (a very small business), and you sell the stock for $101,000 in five years, you will not owe any tax on the gain from the sale of the shares. You can pocket the $25,000 instead of paying it to Uncle Sam.

This creates an extraordinary opportunity for you to incorporate your business, hold onto the stock for the required period of time and then sell the stock without paying any tax on the gain you realize. Also, while you must acquire the stock at its original issuance, your tax break is preserved if the stock is transferred by gift or upon your death. Your holding period carries over to the transferee.

Act Now. While there are many tax and non-tax ramifications to consider before incorporating your business to take advantage of the exclusion of gain upon the sale of the stock, here are some circumstances when it merits serious investigation:

• Your business is thriving and you see great growth potential--this is a great way to ensure the appreciation in value is tax free when you exit the business;
• You want to make it easy to transfer your business to your children or other family members--the exclusion from income applies to gifts of stock; or
• You have key employees that you want to compensate--by making them shareholders you can foster the relationship while providing them with an opportunity for tax-free income.

If any of these apply to you, it's time to talk over your options with a business advisor.

Certain Conditions Apply

Of course, it's tax law that provides this benefit, and that means there are conditions that must be met in order to take advantage of the exclusion. The major requirements are as follows:

Type of business. The business:

• must be a regular C corporation;
• must have $50 million or less in capital;
• must use 80 percent of the value of the corporate assets in the active conduct of business; and
• must not be a personal services business, banking or finance business, leasing business, hospitality business, farming or mining business

Acquisition of stock. You must acquire the stock: before January 1, 2012; at its original issue;
and using money or contributed property (not other stock) or as compensation for services to the corporation.

Holding Period. You must hold the stock for more than five years. With planning, most small business owners will be able to meet these conditions.

While the exclusion on gain is generous, it is not unlimited. For any tax year, you are able to exclude the greater of 10 times your adjusted basis in the stock or $10 million (reduced by any amounts previously excluded). However, dispositions of stock can be structured to maximize the exclusion.

Even with conditions and limitations, this is a planning opportunity that does not happen often. And, it is one definitely worth your time to investigate.

Posted May 2, 2010.

Child's Unearned Income Can Trigger 'Kiddie Tax'

By Marcia Richards Suelzer, Toolkit Staff Writer

If your son or daughter has more than $1,900 of investment (not earned) income, that income might be taxed at your tax rate, rather than at your child's tax rate, as a result of the "kiddie tax" rules.

The "kiddie tax" was enacted back in 1986 to prevent high-income parents from shifting income to lower-income children, thereby reducing the family's overall tax liability. Initially, the provision's nickname, "kiddie tax," seemed to fit: it applied only to children who were under age 14 at the end of a calendar year. But, law changes have expanded its reach to teenagers and young adults, making it an issue for more high-income families.

Example. Frank Burns transfers all of his shares of several biotechnology stocks to his 16-year-old son, Frank Jr. During the year, Frank Jr. receives $5,000 in dividends. Frank Jr. has no earned income. Without the kiddie tax, the $5,000 in unearned income would be taxed at Frank Jr.'s tax rate of 10 percent, rather than his father's 35 percent tax rate. However, as a result of the kiddie tax, the $5,000 is taxed at Frank Sr.'s tax rate.

Income and Age Requirements

The kiddie tax applies only to unearned income, such as interest, dividends and capital gains. Distributions from trusts are generally considered unearned income. It never applies to the child's earned income. The tax on the child's unearned income must be calculated using the parents' tax rate if the child meets any one of these three tests as of the end of the year:

• The child was under age 18 at the end of the year,
• the child was 18 and did not have earned income that was more than half of his or her support, or
• the child was:
• a full-time student;
• over age 18 and under age 24; and
• did not have earned income that was more than half of his or her support.

Electing to Claim the Income on Your Return

Whether your child reports the income on his or her return, or you report it on your return, it is going to be taxed at your tax rate. In recognition of this, the IRS allows the parent to elect to report the child's unearned income provided:

• the child is under 19 (24 if a full-time student) as of December 31;
• the child's only income is from interest or dividends; and
• the child's gross income was $9,500 or less.

Assuming that you can do so, should you elect to report it on your return and avoid the aggravation of filing a return for your child? The answer depends upon your overall tax picture. Adding the child's income to your own will have an impact on any deductions or credits that have limitations based upon adjusted gross income, such as miscellaneous itemized deductions, casualty losses or education credits. If the child's income is substantial and you are close to those limitations, then you will want to calculate the impact both ways.

If the numbers work out, you make the election by filing Form 8814, Parents' Election To Report Child's Interest and Dividends, with your tax return. Otherwise, you would complete Form 8615, Tax for Certain Children Who Have Investment Income of More Than $1,900, and attach it to your child's federal income tax return.