How to Avoid Capital Gains Tax When Selling Qualified Small Business Stock

If you’re starting a corporation or you’re investing in one, you’re probably wondering how to avoid capital gains tax — or if you can avoid it at all. Taxes on investments can be pretty hefty (and complex), but there are some circumstances where you can get a break from the capital gains tax.

In this guide, we’ll walk you through the basics of capital gains taxes, including what they are, how small businesses can qualify for capital gain tax breaks, and more.

What is capital gains tax?

Taxes on capital gains work a little bit like an income tax, but it’s assessed on the sale of capital assets like stock, real estate, and more. It doesn’t apply for capital losses, but that’s not what we’re dealing with here. Let’s focus on capital gains.

There are actually two levels of this federal tax rate. Short-term capital gains (held for a year or less) are taxed in the same tax brackets as personal income taxes (up to 37%, depending on your taxable income). It’s just one of many taxes that can apply to small businesses.

The long-term capital gains tax rate, however, (for assets held for a period of time longer than a year) falls between 0%, 15%, or 20% depending on your taxable income. However, there are a few circumstances where you can get a break from the capital gains tax. That’s where the matter of qualified small business stock comes in.

What is qualified small business stock?

Only certain types of stock qualify as small business stock that can be exempted from the capital gains tax. Generally speaking, a C corporation must not have more than $50 million in gross assets. But the corporation also needs to use the vast majority (80%) of its assets in qualifying trades.

Certain types of businesses, especially professional service businesses, don’t qualify for the tax exemption. This can include law, healthcare, insurance, insurance, farming and natural resources, and more.

Section 1202

Section 1202 of the Internal Revenue Code (IRC) tax code was introduced to encourage investment in small business ventures. That’s why any investor who qualifies can exclude a significant portion of the gain from the capital gains tax. Basically, if the investment qualifies, when the shareholder sells their shares, they will only pay tax on a portion of the investment. They can exclude either 10 times their basis in the stock or $10 million (whichever is greater). Any remaining proceeds are taxable capital gains. 

But to qualify for a Section 1202 exclusion, the stockholder must meet several criteria. First, they have to purchase the stock when it’s originally issued. It must qualify as a long-term gain, too. They have to hold the stock for five years or more. The corporation can have multiple shareholders or just one, making it a viable option for entrepreneurs who want to start their business, grow it, and then sell it for a profit. If you hold stock for less than five years or buy it after the initial offering, you won’t be eligible for Section 1202.For a full assessment of whether your business (or the stock you’re investing in) will qualify for the capital gains tax exclusion, we highly recommend consulting with a financial advisor like a certified public accountant for full guidance. They can coach you through capital loss and gain, other investment income taxes, and small business tax deductions to maximize your tax return.

We can help!

Navigating small business finances and taxes can feel overwhelming. And while we can’t file your taxes for you, we can help with other sides of business. Whether you need help starting a corporation or LLC, maintaining a registered agent, or staying compliant all year, we can help. Let us handle the red tape so you can focus on making your business successful.