This Viral Tax Strategy Will Make You BROKE (You may be doing it)

There. Qsbs. Qualified small business. Sounds very enticing. I can sell my business and pay no tax. It requires a C Corp. The only way you pull this tax strategy off is to have a C Corp for at least five years.

C Corp, not good. We're going to pay tax along the way. Let me tell you why. Let's get really technical here. It's the reason why is EBITDA. So if I'm shooting to save 10 million in tax, I want a $10 million valuation. I better be showing at least $2 million of profit in the year before I sell. That's my friends in federal and state cor tax. That's going to be a half a million. I'm going to have to pay a half a million, close to 25% in taxes to get a valuation of 10 million. Welcome, everyone, to another episode of the Main Street Business Podcast. Mark Kohler here with Matt Sorenson, excited to talk about a strategy that many of you may think is the coolest thing since sliced bread. Or you've heard about it. We're going to unpack that for you today. But it's not just strategies you should do. Maybe it's strategies you shouldn't do.

Yeah, and I know there's a lot of buzz on there. Qualified small business stock QSBS. You might have seen a TikTok or an Instagram or maybe even a YouTube video about it and someone hyping this up for all you small business owners and you hear it in there. Qsbs. Qualified small business. Sounds very enticing. I can sell my business and pay no tax. Tell me more. Is it true?

Sounds so good. You may have heard that 1202 is the same thing. QSBS and 1202 is the same strategy. 1202 is the IRS code section related to that. And yeah, there's a lot of influence. Well, I should say there's a few influencers out there that use this to say you could save $10 million. Don't. Your accountant doesn't know about this. Your accountant's a dumbass. You know what we do know about it? It's just, it doesn't work for everybody. It's very, very limited. So today we're going to tell you why it doesn't work and where it does. And I'm going to choose. We go, why it doesn't work? Because for 98% of people, it doesn't. But we'll talk about the 2% where it can work. And some of you might be in that 2%.

Yeah, well, let's just cut to the chase and talk about why it doesn't work. Now there are some applications of this, so we're not going to cramp on it entirely. And that's how most tax strategies are over promoted. There is a good use case for it. It just doesn't happen to work for most people. So let me just say, and you guys know us, if you listen to the podcast, you know we're have a problem with this. It requires a C Corp. The only way you pull this tax strategy off is to have a C Corp for at least five years. Okay? And you guys know C Corp. When I'm operating that business, what have I decided to pay more taxes than if I had an S corporation? Like you're volunteering for the time you operate and own the business to pay more taxes, hoping that when you sell it you will pay no taxes and that's going to be a better deal. So there's no, there's huge baggage upfront as you're actually running the business year to year.

I love it. And some of you again you can see we're going to tell you when a small business could really do well with this. Let's just think venture capital, maybe a Silicon Valley deal that doesn't have a lot of income, they're not paying a lot of taxes. And we'll kind of talk about that. Again, that narrow exception where that would be a great business to use this election. But Matt just brought it up first. C Corp, not good. We're going to pay tax along the way. Now let me tell you why, let's get really technical here. The reason why is ebitda. Ebitda, that's earnings before interest, tax and amortization. Now what that, why am I bringing this up? Ebitda, Earnings before interest, taxes and amortization. When you go to sell a business, it's got to get valued. What is that business worth? And so if we're going to sell a business for $10 million so I can pay no tax on $10 million or more, nine times out of 10 that valuation is coming from EBITDA. Now yeah, maybe you've got Instagram or LinkedIn or Facebook and it has no profit, but it is going to be worth millions, which is going to be one in a million that you have that invention that everybody wants that actually hasn't made money. But for everybody else out there, when you go to sell your C corporation, they're going to look at ebitda. What's your profit before you pay off Debt and pay taxes and write off goodwill. Like, what is your hardcore profit? Well, if I want a $10 million valuation and we just go with a 5X, which I think is middle of the road, you may even be as low as a 3 or a 4x on a lot of businesses. But if I have, I have to have $2 million in profit and a 5x gives me a $10 million business. So if I'm shooting to save 10 million in tax, I want a $10 million valuation, I better be showing at least $2 million in profit in the year before I sell. That's my friends in federal and state corporate tax. That's going to be a half a million. I'm going to have to pay a half a million, close to 25% in taxes to get a valuation of 10 million. So if I'm paying 500 grand in taxes and I had to that year four and year three and year two and year one, I mean, you add up all those corporate taxes along the way, holy crap. I'd rather pay capital gain and not even play this stupid merry go round. That's a little more detail than maybe you wanted, Matt. I don't know.

Yeah, and well, Mark says 10 million, keep in mind. So what is that gain getting you? When I sell my business, I'm going to get capital gain taxes. That rate is 20%. Maybe you're in a state with, let's say a 5% state income tax, could be in one with none. You know, so, but you know that's on a $10 million gain, right? That, that saving 20%, that could be saving me $2 million. That's, that's big. I get it. We love that. We want tax strategies are going to save you money. The problem is, and I'm just telling you from someone that's done the 10,000 consults, how many clients, small business clients, sell their business for over a million or 2 million bucks, is not that many. But how many of them operate it and make hundreds of thousands or millions a year? There's a lot of those now. So if you have a business that is built to sell and you are like you're a technology company that doesn't have profit but can still sell for a profit. You know, there's different areas where this has been a popular strategy. But the Main street business owner, what we've seen time and time again is if they're selling it, it's not a huge gain. They're more cash flowing the business running it for years, decades sometimes. And me trading C Corp taxes for decades to sell it at one day

when I want to retire, pass it on to my employees or the next generation. It just doesn't.

We just don't see the value of

the QSBS strategy and we don't want all the C Corp baggage to get that. Maybe I sell it later for a profit sometime down the road.

Yep, I love it. Now, problem number two, that was his first problem, folks. Problem number two, it has to be a qualifying business. Not only a C Corp but a qualifying business. And the definition of this in 1202 is any business is okay except for professional service business, law firm, accounting firm, dentists, doctors, gone, banking and broker. Yeah. Farming, oil and gas, mining, hospitality, real estate and any other passive business. So if you've got one of these types of businesses, if you didn't hear me, banking and finance or professional, you can't even do this. So you hear someone talk about and get you so excited your business may not even qualify. And guess what? Most Main street businesses are professional service, banking and finance, Farming, oil, gas, hospitality, real estate. And so again, major roadblock.

Yeah, I mean maybe, maybe you're, you know, this is where we've seen like technology companies, a manufacturing company, construction. Maybe there's some things like that, you know, where we, those, those are use cases for it. And you may want to consider it. But I think you really have to look at the likelihood of you selling your business for a profit before going out and doing this. Like you need to scale and obviously be able to grow your business for this QSBS to work. Now maybe you're someone that's like that. You're like, I've sold a business before. I've been down that road, you know, and I, I can see it. Okay, we, let's talk about that. You know what you're doing, you've done it before. You're with a group of people that do it. So. But I just. The reason we don't talk about it as an initial strategy and it's not on our checklist like of the 30 point tax items on our 30 point checklist, when someone comes into our law firm at KQS Lawyers to do a tax consult, QSBS isn't on it. It's not on it. We'll talk about it and we'll evaluate it, but the reality is most people don't qualify for it. And then even if they do, the baggage of the C Corp tax isn't worth it.

Well, I want to clarify something, Matt, that you said to everybody out There.

Yeah.

A lot of people sell their business for a profit and we know that you're going to sell your business for a profit. But is the profit compared to the cost of getting there? Is what Matt's saying. I'm going to just unpack. I know what Matt's thinking and say. I just want to say it a little differently. We know you could sell your business for a profit. Even if it did qualify. Let's say we get through the qualification. Is the taxes you paid along the way less than what you might sell it for as a profit big enough that differential which you can't predict. Okay, now here's third problem. Third problem, it's called depreciation and amortization. Buyers, unless you're going private equity, hedge funds, Wall street venture capital, they may want to come buy your business, they want stock. But 95% of people that are going to buy your small business are other small businesses. And they're looking to vertically integrate horizontally. Integrate. They're coming in to buy you so that they can get more market share in your town. They're a small business owner buying your small business. That's 90% of the buyers. They don't want to buy your stock. They want to hit reset. They want to hit reset on your equipment and any assets and the goodwill and depreciate them. And they want to amortize the goodwill. They want to write off with what they paid for your business. If they can't hit reset and get stepped up basis by doing an asset purchase, they're stuck. So what do we see in our firm asset purchase agreements. Mark Fetzer is our practice group leader in our law firm for small businesses wanting to sell. If you, if you're thinking of selling and you've been looking at this 1202, make sure you have a consult with Mark Fess. We have fixed pricing to keep it very affordable. To sell a business under a million, over a million or over 10 million, we've got, we can help you. But what we're going to see from buyers, they want an asset purchase agreement, they want to hit resale.

Yeah. And when we're representing a buyer buying a business and when they have a. The business owner that's trying to sell it as a small business, that's a C corp. Not interested, you know, not interested in buying it. So who does your buyer have to be? You've got to have a bigger buyer. It's got to be a more institutional or a big company making smaller acquisitions in your space. It's not going to Be another person wanting to take over your small business. You know that might have a million in profit and that and so that, that and they don't want to see corp. They come to me, I'm like I don't want you buying that C corp. Just buy their assets. You want to go in and buy a C corp and now you've agreed to pay more taxes. So what happens is you have a lower value. The value you can get out of the business is less because less buyers are likely to go out there and offer and in fact if they could just buy your assets they'd pay more.

Now let's talk about when it works. Let's go over. I gave three major problems of course Matt's take on it and my take on it very we're just saying it different ways. Those are the three major hurdles. When does it work? I'm going to give an example. This was in our Main street tax pro training this week. For those that don't know this over MarkJ Kohler.com I've been membership of CPAs and enrolled agents attorneys around the country joining every month to become certified tax advisors. And we twice a week strategizing together. Well one of our members talked about a perfect example of where the 1202 work. He said I've this guy's in his 50s, I think he's in 60s. He says I've only seen five of these in my career that worked. And there was a client that venture capital, this is what it works. A venture capitalist was looking to raise money think of a syndication, private equity. And they went out to accredited investors and said you want in? And one his client went in on LinkedIn. They went on, on LinkedIn, put in several hundred grand. They were one of the original founders and they and but he wasn't a major player in the company. He was just an investor.

Now an individual because you have to be an individual, right? Can't be another company has to be an individual stockholder.

No it was perfect. He was original buyer and original seller. So he, he followed all the rules. It was in the tech industry which qualified as well and LinkedIn was not showing a lot of profit when they sold out. And so but it was venture capital too. They already knew they were going to be a C corp but this so if you want to go into a deal and you could say I'm going to do a five year hold it meets the, the rules. We do have clients that see that coming and they're like hey I'm going to do a 1202 on this. On the outside, you can do a 1202 and everyone else doesn't have to. You as an investor get to make this election if the company that you invested in meets the criteria. So he said his client sold for millions, didn't pay any tax, worked perfectly because it was a venture capital scenario. So very rare again that you're going to meet your client or you out there, that you're going to meet that exception. But if you do bring it.

Yeah. And now you can elect into it, you know, you could be. Now that Mark mentioned, five years. That's this time period that you have to be holding this qualifying small business stock. So just so everybody knows, it's not the company itself that qualifies as a small business. It's at the stockholder level, like me owning this stock. I have to qualify as a qualifying shareholder, which you have to be an individual or a trust. And so Mark's example there with the person in LinkedIn, they were an individual. Let's say there was a venture capital firm that invested into that company and had stock and it wasn't LinkedIn, it was actually LinkedIn.

Yeah.

Oh, okay. So let's say the VC firms, which. There were VC firms that invested into LinkedIn. I mean, they can't get the QSBs. So it's at the individual level of who can qualify. But let's say you are a business owner and you're like, all right, guys, I actually fit into this and I want to go for it. I'm not ready to sell now, but I might be preparing to sell. I'm thinking of transitioning my business. I have good profits. It is a business that could sell. I could get the right type of buyer that would buy C Corp stock. I'm hitting all these buttons where I'm a good fit for this. You can, let's say you're an S Corp or an llc, whatever you may be, you can change your tax classification and get over to C Corp status, and then you got to make it through that five years. And, and we want to do an analysis because this is what we're going to do and see, all right, what are you giving up? Because you're going to have five years of pain, but you can do some analysis and that's where you can just crunch some numbers. Look at your, your state tax situation because that's going to go into account. Corporate taxes are going to be at play now that you haven't experienced before,

may not be familiar with.

And so there can Be an analysis there, and then you can make a

smart determination of whether it applies.

But I think it's a little naive for me to think of people that

worry about this even at startup. At startup, you have no idea and your business might even fail and I make a dollar.

You know what I mean?

And.

And to be thinking I'm going to

elect into this C Corp structure because

I want to start a business I can sell.

I just think it's not right for Main Street. It's the wrong strategy. We love the S Corp because when that business starts making money, you're going to save taxes every year. You're going to keep more money in your pocket. You're going to save taxes every year. You're not waiting until someday, way down the future to get some payoff if you qualify, if you meet all the restrictions and guidelines, and if you've paid your dues paying C Corp taxes along the way.

Well said, my friend. Good job, Matt Sorenson.

All right, that's it. Qs, qsbs. We wanted to set the record straight. And I don't want to say we called out the BS and QSBs, but,

you know, if the shoe fits. If the shoe fits.

If the acronyms work, they just work.

It just works. Well, I want to say this in summary. Again, thank you for listening. And remember, it's really not what strategy you always employ, but which strategy you avoid that could create some problems on the back end. And we, we want to be able to talk about both sides of those and do it in an educated fashion. So when someone pitches you on 1202, you're going to go, I'd listen to a podcast on this. I might review that and send it over to this person and go, really? And so it's just as important to be educated on the strategies that don't work as it is on the strategies that do work so you can protect yourself.

Dang, I love that. That was sage advice right there. Dang, that was good. That was good. It's the just. Yeah, the stuff you don't do that sometimes makes the big difference. Love that. Well, thanks, everyone for being here. Make sure you've subscribed. By the way, this podcast, hit that button and subscribe to it if you're still listening. Now, you got through a podcast on QSBS, section 1202, guys. You like this show? Subscribe already and we'll be back next week with another amazing episode bringing you the tax and legal strategies that can make a difference in your life, not just the ones you need to avoid. We'll see you then.