What Is Qualified Small Business Stock?
Qualified Small Business Stock ("QSBS") is a significant tax incentive designed to encourage investment in and the formation of small businesses in the U.S. Under Section 1202 of the Internal Revenue Code. If someone sells shares of a qualifying C-corporation that they held for at least five years, they can exclude a substantial portion (up to 100% for stock acquired after September 27, 2010) of the capital gains from federal income tax.
How to Qualify
To qualify, the company must be a domestic C-corporation with gross assets not exceeding $50 million at the time the stock was issued. Additionally, the business must be engaged in an active, qualified trade of business (excluding certain service industries like law, accounting, or finance). The stock must also be acquired at original issuance directly from the company. The exclusion is capped at the greater of $10 million or ten times your original investment (adjusted basis) in the stock from that company.
Using the "Stacking" Strategy
While the standard exclusion limit is the greater of $10 million or ten times your adjusted basis in the stock, the real power for tax purposes lies in a strategy typically referred to as "stacking," whereby an individual taxpayer stacks several exemptions on top of one another to collectively exclude more gain than they could individually.
The core principle behind stacking is that the QSBS gain exclusion limit applies per taxpayer. By strategically transferring a person's QSBS to other individuals or entities that are considered separate taxpayers, a transferor can utilize multiple exclusion limits in addition to their own. Upon receiving the transfer, the recipient inherits the transferor's original acquisition date and the QSBS status of the stock. because each individual recipient is a distinct taxpayer, they will each be entitled to their own exclusion. While transferring QSBS outright to individuals such as your children, grandchildren or others is one approach to stacking, it is important to note that spouses typically share a single exemption, and therefore, outright gifts to spouses will not be effective.
Gifting to Non-Grantor Trusts
For clients seeking greater control, asset protection, and multi-generational planning, gifting QSBS to one or more non-grantor trusts is a commonly used strategy. A non-grantor trust is specifically designed to be a separate income tax-paying entity from the original grantor. Each properly structured non-grantor trust can therefore claim its own $10 million or 10x basis QSBS exclusion, effectively creating additional tax savings.
IRS Regulations
For those interested in utilizing the non-grantor trust approach to stacking, it is crucial that the trusts are meticulously drafted to comply with IRS regulations. The IRS has rules to prevent the creation of multiple trusts that are essentially the same from being treated as separate taxpayers.
Strategically planning how QSBS is held and transferred can significantly amplify the available tax benefits when selling such shares, but proper planning and drafting is critical.
For more information on Estate and Tax Planning, contact BakerAvenue to discuss how we can help determine if a QSBS is right for you.
**DISCLAIMER: Baker Avenue Asset Management, LP is a not a law firm or in the business of providing legal or tax advice. This information is being provided as a courtesy for financial planning purposes. We do not provide legal or tax advice. Please contact your attorney before acting on any information provided herein.