I can tell you how to make money and pay no tax.
“Doubtful,” you think, feeling skeptical and remembering that wise mantra “if it sounds too good to be true, it probably is.” True story: last week I was eating at a Chinese restaurant, opened up my fortune cookie, and there were two fortunes inside. If that kind of magic can happen, anything is possible!
Let’s just do a quick refresh on how much tax you usually pay. I’m going to assume for now that you are single, make $130,000 per year, and live in a state with a 5% state income tax.[1]
- As an independent contractor, you get to keep $557 out of every $1,000 you make. [2]
- As an employee, you get to keep $633.5 out of every $1,000 you make.[3]
“Sure,” you say, “But, everyone knows America overtaxes the working class. How much tax do investors pay?”
- If you sell stock you’ve held for less than one year, you get to keep $710 out of every $1,000 of gain.[4]
- If you sell stock you’ve held for more than one year, you get to keep $800 out of every $1,000 of gain.[5]
We’re getting closer to the goal, right?
And here it is: If you sell stock that is qualified small business stock (QSBS) that you’ve held for more than five years[6], you get to keep $1,000 out of every $1,000 of gain.
It bears mentioning that the above result assumes you live in a state which follows the federal tax treatment for QSBS. Unfortunately, California does not. So, in California, you would only get to keep $907 out of every $1,000 of gain.[7]
So, how does one achieve this result? Generally, for stock to get the QSBS benefit, the stock:
- must have been originally issued to the stockholder from the company (i.e., if the stock was purchased from another stockholder, it is not QSBS);
- must have been held for more than five years prior to the date of sale;
And the issuing company must:
- be a domestic C corporation that makes something (software is ok, but the point is the company cannot be a services business);
- have had less than $50M in cash plus asset basis from the date of formation through the date the stock in question was issued;
- have been engaged in an active business during substantially all of the stockholder’s holding period; and
- have made limited repurchases of its own stock.
For additional details regarding the requirements for stock to qualify as QSBS, see here.
I realize that holding onto an investment for 5 years takes patience, but some things are worth the wait!
Mike Baker frequently advises with respect to qualified small business stock. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Texas is 0%, Colorado is a flat 4.63%, and for folks making $130,000 per year, California would be 9.3%.
[2] Federal income tax is 24%, Social Security is 12.4%, Medicare is 2.9%, and state income tax is 5%.
[3] Federal income tax is 24%, Social Security is 6.2%, Medicare is 1.45%, and state income tax is 5%.
[4] Short-term capital gains rate of 24% and state income tax of 5%.
[5] Long-term capital gains rate of 15% and state income tax of 5%.
[6] If you sell the stock before the 5 year holding period, if you reinvest the proceeds within 60 days into new QSBS, you can defer the taxable event to the sale of the new stock and still potentially receive the 0% rate.
[7] I know, I know. Those of you in California are thinking, “I told you it was too good to be true!”