Every construction project needs a plan for completing the work
on time and within budget. Similarly, every contractor needs an exit plan for
eventually leaving the business they've helped build and run.
When you're ready to create yours, be sure to take a close look
at the qualified small business (QSB) stock exclusion. Since the 1990s, this
tax break has given eligible taxpayers the opportunity to gain substantial tax
benefits from selling QSB stock. And last year's One Big Beautiful Bill Act
(OBBBA) further enhanced the exclusion. Let's take a closer look at how it can
apply to exit planning.
C corporation requirement
To qualify for the exclusion, business owners must be
shareholders in a QSB corporation, which is a special type of
C corporation that meets specific requirements. At the entity level, QSB
corporations are generally treated the same as regular C corporations for
legal and federal income tax purposes. So, most of the standard advantages and
disadvantages of C corporation status apply.
On the plus side, these companies are subject to the flat 21%
federal corporate income tax rate. On the minus side, C corporations pay
taxes once at the entity level, and then shareholders may face additional tax
when they receive dividends, compensation or other taxable distributions — or
sell their shares. These two levels of tax obligation are commonly referred to
as "double taxation."
However, individual taxpayers who own QSB stock can potentially
enjoy a significant tax advantage. A special gain exclusion rule may allow them
to avoid federal income tax on up to 100% of the gain from selling their QSB
stock. That's right; when you're ready to exit your construction company, you
may be able to sell your shares in that QSB corporation and pay substantially
reduced — or even zero — income tax on the gain!
Eligibility requirements
To be eligible for any
gain exclusion, various requirements apply. You must acquire the shares in
question after August 10, 1993, and upon original issuance by the
corporation (or by gift or inheritance). Also, your company must be a QSB
corporation on the date the stock is issued and for substantially all the time
you own the shares.
In addition, the corporation must satisfy the QSB gross-assets
test when the stock is issued. This means its aggregate gross assets can't have
exceeded $75 million at any time before the issuance and must not exceed
that amount immediately afterward. A $50 million threshold applies to
stock issued on or before July 4, 2025. The $75 million limit will be
indexed for inflation after 2026.
Another stipulation: Your company must actively conduct a
qualified trade or business. Service businesses and certain others don't
qualify. (We'll discuss this further below.)
Timing is critical, too. To take advantage of the 100% gain
exclusion for sales of QSB stock, you must have acquired the shares after
September 27, 2010, and held them for at least five years. In addition,
for qualifying stock acquired after July 4, 2025, the OBBBA allows the
following partial exclusions for shares held for less than five years:
- 50% gain
exclusion for QSB stock held for at least three years, and
- 75% gain
exclusion for QSB stock held for at least four years.
Any gain not excluded under these partial exclusions is
generally taxed at a special 28% federal rate, plus the 3.8% net investment
income tax, if applicable. The OBBBA increased the per-issuer dollar limitation
on eligible gain from $10 million to $15 million for qualifying
stock. (Other limitations may apply.)
Finer points to consider
There are additional requirements and finer points to consider.
For example, during substantially all of the holding period, at least 80% of
the QSB corporation's assets generally must be used in the active conduct of
one or more qualified businesses. And only "reasonable" amounts of working
capital apply toward this requirement. So, if your company holds significant
cash, real estate or investments not related to your construction operations,
you could have trouble qualifying.
Also, as mentioned, your construction company must be a
"qualified trade or business." The tax code lists a variety of ineligible
fields. Construction isn't among them, but engineering and architecture are.
So, eligibility could become more complicated if a substantial part of your
company's operations or assets is attributable to providing engineering or
architectural services rather than performing construction activities.
Contractors offering design-build or similar integrated services should analyze
this issue carefully.
In addition, businesses whose main asset is the reputation or
skill of one or more employees also aren't eligible. This shouldn't be an issue
for many construction companies, but it could present a barrier for very small
businesses or one-person operations who, for example, position themselves as
master artisans in custom carpentry or another niche. (The application of this
limitation is highly fact-specific; your tax advisor can provide further
information.)
The entity question
As noted, only stock issued by a QSB corporation qualifies for
the exclusion. However, many construction businesses are structured as
pass-through entities. These include partnerships, S corporations and
limited liability companies treated as partnerships for tax purposes. If you
run your business under one of these structures, you have a critical decision
to make: Should you convert to a C corporation with the goal of having
newly issued shares qualify as QSB stock?
There's no simple answer. By converting, you'll forfeit
eligibility for the qualified business income (QBI) deduction, which can allow
you to deduct up to 20% of QBI. But, then again, the federal income tax rate
for C corporations is currently 21%. So, the trade-off may prove worth it
if you expect to incur substantial gains on your exit.
If you're leaning toward converting to a QSB corporation,
advanced planning is vital. You must carefully structure the transaction so the
newly issued stock satisfies the original-issuance and other requirements. The
qualifying holding period generally begins when that stock is issued, so you'll
need to hold the shares for at least three years to qualify for the 50%
exclusion. If you can hold out longer, you may be able to exclude more or even
all of your gain.
Important: The
exclusion generally applies only to an eligible shareholder's sale of QSB
stock. It doesn't shield gain recognized by the corporation if the business's
assets are sold instead, making the anticipated form of a future transaction an
important planning consideration.
Powerful tool
The QSB exclusion can be a powerful exit-planning tool, but it
isn't a last-minute strategy. Determining whether it fits your construction
business requires careful analysis of your entity structure, long-term goals
and anticipated departure date. We can help you weigh the potential savings
against the costs and trade-offs of qualifying for this tax break.
