As a startup founder, the potential to amass significant personal wealth can become a very tangible reality. And it can happen quickly.
However, it’s important to remember that with increased wealth comes increased taxes, which can impact your net after-tax profit. As such, startup founders must consider both tax optimization strategies and Qualified Small Business Stock (QSBS) strategies throughout the various stages of their company’s lifecycle.
This article delves into a variety of tax optimization strategies specific to startup founders’ unique positions. It will provide insights on
- Methods to minimize capital gains tax
- How to reduce state and federal tax liabilities
- Strategies to decrease estate taxes
- Ways to protect assets against claims from creditors or legal actions
Tax optimization and advanced planning are ongoing processes
Before diving into specific tax reduction strategies, it’s important to grasp a fundamental understanding: Tax optimization and advanced planning are continuous processes, not isolated, one-time projects or strategies aimed solely at obtaining a tax break. Throughout your company’s lifecycle, different opportunities will arise, and after exiting, entirely new sets of opportunities will present themselves to you.
Tax laws will change, valuations will fluctuate, and your own priorities, net worth, family, and goals will evolve over time. As a result, your tax strategy and planning are continuous processes that always need attention.
Monitor your company’s equity value
Managing your equity value throughout your company’s life cycle is an important concept of tax optimization. By carefully assessing the current value of your shares and considering your expectations of their future value, you can capitalize on different tax reduction strategies that present themselves as your company grows.
Utilize Qualified Small Business Stock (QSBS)
Qualified Small Business Stock (QSBS) is referred to as the Section 1202 exclusion of the Internal Revenue Code (IRC). It’s one of many tax reduction strategies that can potentially be a lucrative tax minimization opportunity for founders.
By excluding up to $10 million (or 10x basis) of capital gains from taxation upon an exit or sale, QSBS offers significant advantages to eligible individuals and certain trusts.
These tax benefits could potentially lead to savings of up to 23.8% on federal income taxes. Additionally, depending on your state of residence, you might save more on state taxes by leveraging the Section 1202 exclusion, depending on your jurisdiction.
Wondering if you’re eligible for QSBS? Dive into our detailed guide for a deeper understanding of how QSBS can serve as one of your tax minimization strategies. The guide will examine the intricacies of the QSBS exclusion criteria, focusing on holding periods, qualifications for shareholders, and other QSBS rules.
Alright, let’s explore a few of the various tax optimization and Section 1202 exclusion planning strategies.
QSBS Stacking with a Non-Grantor Trust
To maximize or multiply the QSBS exclusion (also known as QSBS Stacking), many founders consider gifting QSBS-eligible stock to an irrevocable non-grantor trust. This qualifies the trust for its $10 million exclusion.
For example, imagine a scenario where a founder sets up three trusts: one for each of their children as beneficiaries, and gifts $10 million of Qualified Small Business Stock (QSBS) to each trust. This tax strategy would result in a total QSBS gain exclusion of $40 million.
This means that the founder would not pay federal tax on $40 million. Additionally, using a tax-exempt state such as Texas, Delaware, or Nevada can provide further opportunities for tax optimization. It’s important to note that the example below focuses solely on federal taxes.
For those looking to delve deeper into this topic, our article on QSBS stacking goes beyond the fundamentals to cover the complexities of maximizing the Section 1202 exclusion. It digs into everything you should know on how you can implement the strategy of QSBS Stacking.
Consider a parent-seeded trust for state tax and estate tax benefits
To plan for future generations by reducing estate taxes and to minimize state taxes (such as those in New York or California), establishing a parent-seeded trust can be an attractive tax strategy. This is established by the parents of the founder, with the founder as the beneficiary.
The process involves the founder selling his/her shares to the trust. The advantage is that any future increase in the value of shares transferred to the trust is removed from the founder’s and the parents’ estates, thereby not being subject to potential future estate taxes.
This strategy also does not utilize any lifetime gift exemption. Additionally, the trust can be located in a tax-exempt state to avoid state-level taxes.
The trustee, chosen by the founder, can make distributions to the founder if desired. This trust can also be used for the benefit of multiple generations.
Distributions can be made at the discretion of the trustee, and this skips the estate tax liability as assets are passed from generation to generation. However, it’s important to note that this would disqualify the ability to claim QSBS.
Transfer the upside and reduce future estate taxes with a GRAT
This approach enables the founder to decrease their estate tax liability and transfer the potential growth of their shares into a trust. It shifts wealth out of their estate without using their lifetime gift exemption or incurring gift tax. It proves particularly beneficial for individuals who have already exhausted their lifetime gift tax exemption limit and hold “unicorn” sized positions.
In a Grantor Retained Annuity Trust (GRAT), the founder (grantor) moves assets into the GRAT and in return, receives a series of annuity payments back from the GRAT. The calculation of these payments considers the IRS 7520 rate. If the growth of the assets within the trust exceeds the IRS 7520 rate, the GRAT will have a remainder amount after the annuity payments have been returned to the founder.
This remainder amount is what is not included in the founder’s estate and can be passed on to heirs or a trust. It potentially amounts to several times the original value contributed.
For stock that is expected to pop in value, using a GRAT could be extremely advantageous. This would allow any increase in value to occur within the trust and be transferred to heirs free from gift and estate taxes.
Also, since the trust is designed as a grantor trust, the founder has the option to cover the taxes generated by it. But it’s important to note that for the success of this tax strategy, the grantor must outlive the term of the GRAT.
If the grantor passes away before the term concludes, the strategy could be invalidated. This can potentially result in the assets being included in the grantor’s estate as though the GRAT had never been established.
Get greater flexibility in wealth transfer with IDGT
The intentionally defective grantor trust (IDGT) offers similar benefits to the GRAT in minimizing estate tax liability. The grantor seeds the trust with 10% of the asset value intended to be transferred and utilizes some lifetime gift exemption. The remaining 90% is sold to the trust in exchange for an interest-only promissory note.
This sale is not taxable for income tax or QSBS purposes. Since it is interest only, the payments back to the founder are much lower than the above GRAT strategy annuity payments.
Another significant difference is the IDGT approach offers greater flexibility than the GRAT and allows for generation-skipping. If the objective is to bypass the generation-skipping transfer tax (GSTT), the IDGT proves to be more advantageous than the GRAT.
This is because, with an IDGT, assets are valued for GSTT purposes at the time of contribution to the trust before they appreciate. This differs from a GRAT where assets are valued after appreciation at the term’s end.
Conclusion
Tax optimization and tax planning should play a significant role in your personal wealth journey as a founder or business owner. As you explore the various tax minimization strategies such as QSBS, a GRAT, using a Parent Seeded Trust, or an IDGT outlined above, remember that many can be combined and/or implemented at different stages within your company’s life cycle.
What we’ve covered here merely scratches the surface of tax planning strategies, and there are many other exit planning strategies that are not mentioned. In the end, this is all highly customized based on your own opportunity set, and there is no one-size-fits-all tax strategy.
We advise closely monitoring your equity ownership at every stage of your company’s lifecycle to ensure it aligns with your personal goals and aspirations. This might include considering tax optimization, tax planning, wealth transfer, or creating a family legacy.
Given the complexities involved, these strategies require professional counsel from attorneys and tax advisors to go along with careful planning. Read more about this subject on our published article written by KGP’s Peyton Carr on Forbes.com.
FAQs
How can I optimize my taxes as a founder?
Various tax saving strategies are available such as:
- Utilizing a non-grantor trust with qualified small business stock (QSBS)
- Establishing a grantor-retained annuity trust (GRAT)
- Creating a parent-seeded trust
- Using an intentionally defective grantor trust (IDGT)
Each tax strategy, and many others not mentioned, has its own benefits and drawbacks, and may or may not be suitable for different situations. It’s important to consult with professionals and carefully plan before implementing any tax optimization strategy.
Why is tax planning important for founders and business owners?
As a founder or business owner, your personal wealth is very closely tied to the success of your company. Effective tax planning, especially prior to an exit event or company sale, can help minimize your tax liability and maximize your wealth.
This involves considering various tax saving strategies that align with your personal goals. It may include taking advantage of available exemptions, shifting wealth out of your estate, or utilizing trust structures.
How do I know which tax minimization strategies are best for me?
The best tax minimization strategies for you will depend on your specific situation and goals. It’s important to consult with professionals who can provide personalized advice based on your individual circumstances.
This may include attorneys, tax advisors, and wealth managers who can help you navigate the complexities of tax planning and identify the most suitable strategies for your needs. Consider seeking professional counsel before making any decisions about tax optimization.
Remember that these tax reduction strategies require careful planning and consideration, and what may work for one individual or business may not necessarily be the best fit for another. It’s also crucial to regularly review and reassess your tax planning strategies as your financial situation and goals may change over time.
Effective tax planning can help you optimize your taxes, minimize your tax liabilities, and maximize your wealth transfer to future generations. These factors make planning an important aspect of personal wealth management for founders and business owners to consider.
What is the exclusion limitation for QSBS?
The exclusion limitation for QSBS (qualified small business stock) is currently set at up to $10 million or 10 times the initial investment, whichever is greater. This means eligible investors can exclude up to $10 million in capital gains from the sale of qualified small business stock or up to 10 times their initial investment amount (basis), if greater if they qualify.
There are additional tax reduction strategies, such as QSBS stacking, that I mentioned above that can multiply this exemption. It’s important to consult with tax professionals for personalized advice regarding QSBS eligibility and exclusion limitations.
Can I combine different tax minimization strategies?
Yes, it is possible to combine multiple tax minimization strategies as part of your overall tax strategy. This is especially the case at different stages of your company’s lifecycle.
However, it’s essential to carefully consider each tax strategy’s individual benefits and limitations, as well as how they may interact with one another. Consulting with professionals can help ensure that your tax planning is optimized and tailored to your specific circumstances.
Remember that tax planning is highly personalized. As such, it should be regularly reviewed and adjusted as needed.
Are there any other tax optimization strategies available besides the ones mentioned?
Yes, there are many other tax saving strategies available besides the ones mentioned in this here that can range from simple to complex. The best tax strategy for you will depend on your individual goals and circumstances, so it’s important to consult with professionals, regularly review, and adjust your tax planning strategies as needed.
How can you minimize taxes?
Various planning strategies can help minimize taxes, including:
- Tax deductions
- Trusts
- Exemptions
- Exclusions
- Credits
- Utilizing accounts with favorable tax treatment
Additionally, engaging in effective tax planning and implementing suitable tax saving strategies can also reduce your overall tax liability. It’s important to consult with professionals to determine the most appropriate approach for your specific situation and goals.
Can tax optimization strategies also help with wealth transfer and creating a family legacy?
Yes, tax optimization strategies can also play a significant role in wealth transfer and creating a family legacy. By minimizing your tax liability, you can preserve more of your wealth to pass down to future generations.
Additionally, certain trust structures and estate planning techniques can also be used as part of an overall tax optimization strategy to help transfer wealth to future generations while minimizing taxes. Consult with professionals for personalized advice on how to best achieve your wealth transfer and legacy goals through tax saving strategies. They can be powerful tools in building and preserving a lasting family legacy.
