Here is how you can start a new business, pay 15 percent Income Tax on the profits, pay no tax on the sale of the business, and still protect your investment from creditors.
Dr. Ramos always loved plants and dreamed of owning a small nursery. After meeting with his tax attorney, he heard about a little known technique available to new businesses that would allow him to pay 15 percent tax on the profits and completely avoid capital gains tax when he sells his nursery business down the road.
Under Section 1202 of the Internal Revenue Code, there is no tax on the sale of Qualified Small Business Stock (“QSBS”) held for more than 5 years. A QSBS is generally original issue stock from certain “C” corporations that are engaged in qualified, active trades or businesses. There are additional requirements relating to percentage of assets used in the active trade or business, but certain types of businesses do not qualify. Unfortunately, professional businesses such as medical, law, or accounting firms do not qualify. But most other businesses do.
The first $50,000 of taxable income for a “C” Corporation is taxed at 15 percent by the U.S. Florida does not impose corporate income tax on the first $50,000 of taxable income.
Thus, the Income Tax on $50,000 taxable income amounts to $7,500 per year. Assuming no dividends and reinvestment of the $42,500 net after taxes by the “C” corporation, there should be well in excess of $212,500 after 5 years.
At that point, Dr. Ramos sells his stock to a third party for fair market value. There is no tax capital gains tax to Dr. Ramos thanks to Internal Revenue Code Section 1202. There is no Alternative Minimum Tax as well.
For asset protection purposes, we would use an LLC for the nursery business rather than a corporation. Recall that if Dr. Ramos were sued for medical malpractice, etc., the creditor’s sole remedy would be to obtain a “charging order” on Dr. Ramos’ interest assuming we made Mrs. Ramos or another family member an owner as well. However, we would make an election to have the LLC treated as a “C” corporation in order to gain the advantage of the Income Tax exclusion on the sale of the interest and the modest rates on its current income.
In summary, this technique provides the following benefits: (i) 15 percent tax rate on current income because the election to be treated as a ”C” corporation was made; (ii) tax free sale of the business interest after 5 years; and (iii) since the organizational entity is an LLC, a creditor of a member (usually the doctor) would be limited to a “charging order” and could not attach the business interest.