This article was originally published on Forbes.com and written by Peyton Carr.
Imagine pocketing millions more from your startup exit, all thanks to a few Qualified Small Business (QSBS) rules and tax savings strategies. Exit planning for company founders with considerable holdings in domestic C Corporation Section 1202 Qualified Small Business Stock (QSBS), isn’t just a dream—it could be a very attainable reality. Leveraging the underutilized yet potent tax benefits of QSBS stacking and the internal revenue code, a founder can potentially boost their post-exit earnings. New to the QSBS rules? Catch up with my founder’s QSBS guide here. In this article, we’re going beyond the basics to explore a few advanced strategies designed to ‘stack’ multiple QSBS stock exclusions.
Timing is very important when considering the strategies I touch on below to achieve the maximum tax benefit. The optimal window is when an exit becomes a likely reality, but certainly well before a formal offer has been signed. Waiting too long, such as until you have a signed offer to sell your company, could expose you to tax liabilities via assignment of income. There are internal revenue code rules that specify that if there are no major contingencies left to clear between the signing and closing dates, the effective date for the transaction is likely the signing date, not the closing date. So, it’s important to pre-plan for this.
1. Gifting QSBS Outright
One straightforward approach entrepreneurs and company founders might contemplate is the outright gift of QSBS to a family member (other than a spouse), such as a child or parent, or to another eligible individual. By making this donative transfer, individuals can potentially stack QSBS exclusions. While this may be the most straightforward approach, it is often not the best. What outright gifts gain in straightforwardness, they lack in a few other areas, such as creditor protection, control, and effective use of your gift tax exemption. Due to these limitations, this is generally not the strategy I suggest.
2. Non-Grantor Trust(s) – Completed Gifts
One of the more advanced QSBS trust stacking strategies that company founders might consider is the option of gifting QSBS to an irrevocable non-grantor trust(s). This allows the trust(s) to qualify for its own $10 million exclusion. In this strategy, the founder is the grantor, and the trust beneficiary(s) would typically be children, relatives, or unborn children. It’s necessary, however, to be mindful of an IRS rule, which addresses circumstances where multiple trusts are treated as a single entity if they share substantially the same beneficiaries or grantor. In other words, if you plan to create multiple trusts, they cannot be exact copies of one another.
Take, for instance, a scenario where a founder has three children, creates a QSBS Non-grantor trust for each child, and gifts $10 million of QSBS to each trust. In doing so, the founder has effectively “stacked” QSBS and created $40 million excluded from federal income tax and capital gains. See the example below.
In addition to the federal income tax purposes capital gains tax benefits, there are also state tax benefits to consider. Structuring the trust in a tax-friendly state, such as Delaware or Nevada, could potentially minimize tax upon an exit altogether. In scenarios where state tax is applicable, some jurisdictions, like New York, conform to the federal tax treatment of QSBS, while other states, like California, do not.
One important item worth considering is that gifting QSBS shares to a trust will use part of your lifetime gift tax exemption. It’s strategic to make this move well before an exit when asset valuations are generally lower rather than waiting until the exit event is imminent. This approach enables you to optimize the efficiency and utilization of your lifetime gift tax exemption.
3. GRAT Strategy – Gift of Remainder Interest
A Grantor Retained Annuity Trust (GRAT) serves as a tax-efficient method for founders to transfer assets to beneficiaries, thereby minimizing estate and gift tax obligations. The company founder places assets in the GRAT and receives annuity payments in return, which are calculated based on the IRS interest 7520 rate. If the assets grow faster than this interest rate, the excess amount remains in the trust and can be transferred to the beneficiaries tax-free after the trust’s term expires. The remaining portion, known as the remainder interest, may be eligible for QSBS (Qualified Small Business Stock) qualification if it’s transferred to another individual (excluding the grantor) or to a non-grantor trust.
This strategy proves valuable for founders planning for an exit who have fully utilized their lifetime gift tax exemptions. Nevertheless, it’s crucial for the founder to survive the trust’s term; otherwise, the advantages are forfeited, and the assets revert to the founder’s estate. When contemplating this approach, it’s essential to carefully evaluate the benefits in light of the associated limitations.
4. Charitable Remainder Unitrust (CRUT)
Another advanced strategy to further enhance or rather “stack” Section 1202 QSBS entails transferring the fair market value of the shares into a Charitable Remainder Unitrust (CRUT). This allows the CRUT to potentially qualify for its own $10 million exclusion, based on the QSBS rules, and the founder will get a generally small charitable deduction. Then, on an annual basis, the founder receives “unitrust” distributions from the CRUT, determined as a fixed percentage of the CRUT’s asset value. This percentage can typically range from 5% to 50%, depending on certain guidelines and the trust’s term. The shorter the term, the higher the annual distributions until the assets are distributed back to the founder.
Given the tax-exempt status of the CRUT, it avoids immediate taxation upon asset sales. Nevertheless, the founder will incur taxes on periodic distributions, structured under a tiered system where the portions subject to higher taxation are distributed first. But, in the event the CRUT qualifies for its own Qualified Small Business Stock (QSBS) exclusion, a $10 million gain within the CRUT could be potentially exempt from taxation when eventually distributed to the founder. This is potentially another way to stack QSBS.
Founders who possess domestic c corporation Qualified Small Business Stock (QSBS) have a variety of strategic choices to contemplate. By delving into these strategies, the tax code, and following the QSBS rules designed for small businesses, individuals may enhance their post-tax results. It is crucial to approach such planning with meticulous thoughtfulness and to seek the counsel of tax advisors and legal professionals for alignment with personal circumstances and goals.
The information and opinions provided in this material are for general informational purposes only and should not be considered as tax, financial, investment or legal advice. The information is not intended to replace professional advice from qualified professionals in your jurisdiction.
Tax laws and regulations are complex and subject to change, and their application can vary widely based on the specific facts and circumstances involved. Any tax information or advice in this article is not intended to be, and should not be, used as a substitute for specific tax advice from a qualified tax professional. You should consult with a licensed professional for advice concerning your specific situation.