Estate Planning for Founders - Part II: Planning with Qualified Small Business Stock
This is the second of a four-part series focusing on estate planning fundamentals for founders. This article will address an important topic for owners of Qualified Small Business Stock (QSBS) as defined in Section 1202 of the Internal Revenue Code.
If you own stock that is QSBS, you are probably aware that you may be eligible to receive a significant exclusion on capital gains taxes when you sell your company. What founders do not often know is that they can multiply this exemption using certain types of trusts.
To understand this concept, some tax background is necessary. Under the Internal Revenue Code (§ 1202), QSBS stockholders who obtained their stock after February 27, 2010, are eligible to exclude the greater of (i) ten times (10X) their adjusted basis in the stock or (ii) $10 million from their amount realized, thus reducing the capital gains taxes they would otherwise pay on the sale of the stock. (Note, shareholders who obtained their stock earlier than February 27, 2010, may still qualify subject to either a 75% or a 50% exclusion as opposed to 100%, depending upon the date one obtained the stock.) As a practical matter, for most founders this equals $10 million since their basis in their stock is often next to zero (i.e., par value), although this is not always true. We will refer to this as the QSBS exclusion for the purposes of this article. (For simplicity, we will not go into detail here as to what stock qualifies for the QSBS exclusion. You should discuss whether you qualify with your tax advisors.) Assuming your stock is QSBS, then if you give your stock to someone else, the person receiving this stock is eligible for his or her own separate QSBS exclusion. (See I.R.C. § 1202(h)(1).)
It is generally not recommended to give stock outright to family members for various reasons. Trusts are much better vehicles for making large gifts. In 2024, you can give away $13.61 million without any gift taxes being due (known as the “lifetime gift tax exemption”). For married couples, that amount is doubled. After you use up the lifetime gift tax exemption, there is a 40% tax on every dollar given away during your life or transferred at your death.
When you give assets to a trust, you may use some or all of your lifetime gift tax exemption, but the assets in the trust appreciate and benefit your descendants gift and estate tax free for the term of the trust. In certain states like Delaware, that period of time can be indefinite. Further, trusts shield the trust assets from creditors (such as divorcing spouses, for example) of the trust beneficiaries. Accordingly, if the trust is properly structured, creditors cannot gain access to the trust assets unless those assets are distributed to the beneficiary.
If you give QSBS to a “non-grantor trust” then the tax rules imply that the stock in the hands of a trustee should qualify for its own QSBS exclusion as well. A non-grantor trust is a trust that pays its own income taxes and in order for a trust to obtain its own QSBS exclusion, there must be a gift to a trust which pays its own income taxes. This is different than a gift to a “grantor trust” where the grantor (the creator of the trust) pays the income taxes on trust income. A gift of QSBS to a grantor trust will not result in an additional QSBS exclusion in the hands of the trustee because all of the income is imputed to the grantor and he or she will still only have one QSBS exclusion.
For example, assume a founder is married with three (3) children. The founder holds QSBS stock with a market value of $10 million. The founder anticipates that on an exit in a few years, the stock will have a market value close to $40 million. The founder’s basis is $100 in the stock. Let us assume that the top marginal rate of 20% capital gains applies to the future sale plus the 3.8% net investment tax for a total effective rate of 23.8%. If the founder holds the stock until the exit, the founder would owe the federal government over $7 million in capital gains taxes when factoring in the benefit of the QSBS exclusion given to the founder.
However, if the founder creates three (3) irrevocable non-grantor trusts, one (1) for each of the founder’s three (3) children, and the founder gives 75% of the founder’s stock equally to the three (3) trusts (and retaining the remaining 25%), the founder and each trust effectively has $10 million of gain which is reduced by the $10 million QSBS exclusion. The founder’s family would now have zero (0) federal capital gains taxes due and will have saved over $7 million in capital gains taxes at the federal level.
Depending upon what state you live in, it may be possible to minimize certain capital gains taxes owed at the state level as well, particularly if your state does not have its own QSBS exclusion for state income tax. Regardless of your state of residence, if you set up your trusts in a state with no income tax, such as Delaware, Wyoming, Nevada or Alaska, it may be possible to avoid or delay state income taxes on the QSBS sold in each trust. This is because each trust is a taxpayer in the resident state of the trust, such as Delaware, Wyoming, Nevada or Alaska, as opposed to the state of your residency. The trusts pay no state-level income taxes on undistributed income if they are created in a state without a state income tax. Note that this is a state-by-state analysis as some states have tax laws that mitigate this planning at the state level, so, again, consult with a competent tax advisor on such matters.
There are some disadvantages to this planning. An important one is that you are giving up all rights to the stock as well as any proceeds from a sale with respect to that stock. Generally, you cannot get this stock (or proceeds of its sale) back after you give it away, so you should only give an amount that you are comfortable giving up, not necessarily an amount that maximizes your tax savings.
As you can see, QSBS planning is very valuable and can save certain founders and their beneficiaries millions of dollars in capital gains taxes if properly executed. In our next article, we will discuss how founders who do not own QSBS can minimize any potential estate tax liability they may have on their death as well as transfer ownership of the business to family members. Check back soon!
If you own stock that is QSBS, you are probably aware that you may be eligible to receive a significant exclusion on capital gains taxes when you sell your company. What founders do not often know is that they can multiply this exemption using certain types of trusts.
To understand this concept, some tax background is necessary. Under the Internal Revenue Code (§ 1202), QSBS stockholders who obtained their stock after February 27, 2010, are eligible to exclude the greater of (i) ten times (10X) their adjusted basis in the stock or (ii) $10 million from their amount realized, thus reducing the capital gains taxes they would otherwise pay on the sale of the stock. (Note, shareholders who obtained their stock earlier than February 27, 2010, may still qualify subject to either a 75% or a 50% exclusion as opposed to 100%, depending upon the date one obtained the stock.) As a practical matter, for most founders this equals $10 million since their basis in their stock is often next to zero (i.e., par value), although this is not always true. We will refer to this as the QSBS exclusion for the purposes of this article. (For simplicity, we will not go into detail here as to what stock qualifies for the QSBS exclusion. You should discuss whether you qualify with your tax advisors.) Assuming your stock is QSBS, then if you give your stock to someone else, the person receiving this stock is eligible for his or her own separate QSBS exclusion. (See I.R.C. § 1202(h)(1).)
It is generally not recommended to give stock outright to family members for various reasons. Trusts are much better vehicles for making large gifts. In 2024, you can give away $13.61 million without any gift taxes being due (known as the “lifetime gift tax exemption”). For married couples, that amount is doubled. After you use up the lifetime gift tax exemption, there is a 40% tax on every dollar given away during your life or transferred at your death.
When you give assets to a trust, you may use some or all of your lifetime gift tax exemption, but the assets in the trust appreciate and benefit your descendants gift and estate tax free for the term of the trust. In certain states like Delaware, that period of time can be indefinite. Further, trusts shield the trust assets from creditors (such as divorcing spouses, for example) of the trust beneficiaries. Accordingly, if the trust is properly structured, creditors cannot gain access to the trust assets unless those assets are distributed to the beneficiary.
If you give QSBS to a “non-grantor trust” then the tax rules imply that the stock in the hands of a trustee should qualify for its own QSBS exclusion as well. A non-grantor trust is a trust that pays its own income taxes and in order for a trust to obtain its own QSBS exclusion, there must be a gift to a trust which pays its own income taxes. This is different than a gift to a “grantor trust” where the grantor (the creator of the trust) pays the income taxes on trust income. A gift of QSBS to a grantor trust will not result in an additional QSBS exclusion in the hands of the trustee because all of the income is imputed to the grantor and he or she will still only have one QSBS exclusion.
For example, assume a founder is married with three (3) children. The founder holds QSBS stock with a market value of $10 million. The founder anticipates that on an exit in a few years, the stock will have a market value close to $40 million. The founder’s basis is $100 in the stock. Let us assume that the top marginal rate of 20% capital gains applies to the future sale plus the 3.8% net investment tax for a total effective rate of 23.8%. If the founder holds the stock until the exit, the founder would owe the federal government over $7 million in capital gains taxes when factoring in the benefit of the QSBS exclusion given to the founder.
However, if the founder creates three (3) irrevocable non-grantor trusts, one (1) for each of the founder’s three (3) children, and the founder gives 75% of the founder’s stock equally to the three (3) trusts (and retaining the remaining 25%), the founder and each trust effectively has $10 million of gain which is reduced by the $10 million QSBS exclusion. The founder’s family would now have zero (0) federal capital gains taxes due and will have saved over $7 million in capital gains taxes at the federal level.
Depending upon what state you live in, it may be possible to minimize certain capital gains taxes owed at the state level as well, particularly if your state does not have its own QSBS exclusion for state income tax. Regardless of your state of residence, if you set up your trusts in a state with no income tax, such as Delaware, Wyoming, Nevada or Alaska, it may be possible to avoid or delay state income taxes on the QSBS sold in each trust. This is because each trust is a taxpayer in the resident state of the trust, such as Delaware, Wyoming, Nevada or Alaska, as opposed to the state of your residency. The trusts pay no state-level income taxes on undistributed income if they are created in a state without a state income tax. Note that this is a state-by-state analysis as some states have tax laws that mitigate this planning at the state level, so, again, consult with a competent tax advisor on such matters.
There are some disadvantages to this planning. An important one is that you are giving up all rights to the stock as well as any proceeds from a sale with respect to that stock. Generally, you cannot get this stock (or proceeds of its sale) back after you give it away, so you should only give an amount that you are comfortable giving up, not necessarily an amount that maximizes your tax savings.
As you can see, QSBS planning is very valuable and can save certain founders and their beneficiaries millions of dollars in capital gains taxes if properly executed. In our next article, we will discuss how founders who do not own QSBS can minimize any potential estate tax liability they may have on their death as well as transfer ownership of the business to family members. Check back soon!