If you’re familiar with the basics of qualified small business stock (QSBS) and the associated tax benefits, it’s exciting to learn that you could realize as much as $10 million of federal tax-free gains. But why stop there?
For many taxpayers, the ability to pay zero federal tax on $10 million could be just the beginning. If saving federal tax on $10 million is like hitting a single in baseball, what can you do with a double, a triple, or even a home run?
What Is QSBS?
Let’s first revisit some of the basics.
QSBS was introduced in the tax code in 1993 as Section 1202 of the Internal Revenue Code (IRC) permitting a partial exclusion on qualifying gains.
The law evolved over time, but it became more exciting when changes were made in September 2010 that eliminated the federal tax on qualifying sales.
Why Is QSBS a Great Opportunity Now?
While QSBS has been a great opportunity for years, taxpayers are becoming more educated and aware of the benefit, increasing activity around seeking the gains.
While this tax-free benefit is still available, it could potentially change should federal and state tax rates rise, or changes be made to tax law. Many people never look beyond the basic federal benefits for QSBS and miss out on the potential estate and gift and state savings opportunities as well.
How to Qualify for QSBS
Here are five general requirements, among many, to consider when a noncorporate taxpayer sells stock.
1. The stock was purchased from a domestic C corporation at original issuance after September 27, 2010.
There are three levels of potential gain exclusion at:
- 50%, purchased before February 18, 2009
- 75%, purchased February 18, 2009 to September 27, 2010
- 100%, purchased after September 27, 2010
2. The stock must be in a qualified industry— the code specifically excludes certain industries including some service businesses, financial companies, energy production, farming, and hospitality.
3. Active business requirement— at least 80% of the value of the corporation’s assets must be used in the conduct of an active business, not an inactive business or an investment holding company.
4. The stock must have been held for at least five years.
5. Immediately after issuance, the corporation had less than $50 million of aggregate gross assets.
While these requirements may seem straightforward, they can be become quite complicated in practice. To learn more, see Qualified Small Business Stock Is An Often Overlooked Tax Windfall.
QSBS Tax Benefit Opportunities
To explore the additional opportunities with QSBS, let’s assume you meet these requirements and hold qualifying shares under Section 1202. An outline of potential benefits follows.
1. Exclude $10 Million of Capital Gains
To stick with the baseball theme, this next step is like hitting a single.
The most common benefit associated with QSBS is the ability to exclude from federal tax up to $10 million of capital gains or 10 times your cost basis, whichever is higher.
Sample Tax Savings Breakdown
2. Gift Qualifying Stock for a Boost Upon Sale of the Stock
This is the equivalent of reaching second base.
Section 1202 provides that each noncorporate taxpayer is entitled to their own gain exclusion for stock that they own.
This potentially opens the door for a taxpayer holding qualifying stock to gift that stock to another taxpayer so they can in turn receive all the benefits of QSBS upon sale of the stock. This is possible because the gifted shares generally carry with them the QSBS attributes as well as tacked holding period and carryover cost basis.
For example, this may apply to a gift made to an individual outright—to a child or other relative, for example—or made to an irrevocable nongrantor trust for the benefit of a child or relatives.
Sample Tax Savings Breakdown
You must follow the rules for reporting a completed gift, valuing the shares of stock at the time of the gift and likely using up some of your lifetime gift and estate tax exemption.
Under current law, the lifetime gift and estate tax exemption is $11.7 million. So, in the above example, if you gift the shares to the trust when they’re valued at $10 million, you use up $10 million of your lifetime exemption.
This may not be a bad thing because you’ll want to use your exemption on something during life or at death. And you may want to use it sooner rather than later if you believe the current Congress and administration may reduce the allowable exemption.
Note, that you can also make the gift much earlier in your holding period when the share value is lower to mitigate this issue.
This is a simplified example and these rules can become complex. It’s also important to note that while Section 1202 appears to allow for this technique, the IRS has yet to comment or provide any formal guidance.
It’s important to work with your tax advisor to determine if this strategy may be available based on your specific facts and circumstances prior to executing such an arrangement.
3. State Tax-Free Treatment
If you want to hit a triple with QSBS, you might consider going for tax-free treatment at the state level.
You may be able to accomplish this in numerous ways, such as by establishing your residency in a state that has one of the following criteria:
- No income tax
- No capital gains tax
- Conforms to the federal treatment for QSBS
The good news is that most states allow you to get tax-free treatment, with a few exceptions—most notably California, Pennsylvania, Alabama, and Mississippi. Note that Massachusetts, New Jersey, and Hawaii only partially conform to federal QSBS rules.
Does California Allow QSBS Exclusions?
Unfortunately, California, including the technology and small business investment-rich environment of Silicon Valley, doesn’t conform to the federal QSBS rules or provide any tax benefit for selling QSBS.
Sample Tax Savings Breakdown: Former California Resident
You need to be a resident of the right state at the time of sale.
In other words, if you don’t already live in a tax-free state or QSBS conforming state and aren’t willing to move, this strategy isn’t available to you.
If you’re willing to move, there’s potentially big tax savings if you properly sever ties with your existing state and establish residency in your new state. Depending on your facts and circumstances, changing state residency can be a simple process or it can require extensive planning with state and local tax professionals to achieve a successful result.
The one caveat to this: There may be ways to establish a trust in another state—and still have the trust qualify for QSBS benefits—without having to move your residency to that other state.
4. Additional Tax Savings with Rollover Method
With all this talk of base hits, what does a QSBS home run or maybe even a grand slam look like?
One method is to use the provisions of IRC Section 1045 to do a QSBS rollover.
Let’s say that you have a large amount of QSBS and have:
- Realized the maximum $10 million tax-free gain personally
- Funded a trust using your lifetime gift exemption
- Moved from a high-tax state, such as California, to a tax-free state so that all this wasn’t only federal tax-free, but also state tax-free
In this scenario, you could consider a rollover if you still have QSBS remaining.
Section 1045 allows you to rollover your gain from the sale of QSBS to a replacement QSBS investment within 60 days of selling your stock so long as you held the original QSBS for at least six months and met the other requirements of Section 1202.
Once you’ve established your position in the replacement QSBS investment, so long as you continue to meet the requirements of Section 1202, you can then sell the QSBS in the replacement issuer and potentially qualify for a new set of benefits—the cycle may start over again with a new $10 million, for example.
Sample Tax Savings Breakdown: Former California Resident
So, what’s the catch with attempting to hit a home run or grand slam? The first catch really isn’t a catch at all: With the replacement QSBS investment, just like the original QSBS investment, you want to be sure you meet the Section 1202 requirements.
This would include the active business requirement, especially if your replacement QSBS is purchased in a start-up that you control.
Again these rules can be complex, and while the code appears to support that a successful Section 1045 rollover provides a new set of opportunities and benefits with a new issuer under Section 1202, this combination of Sections 1202 and 1045 hasn’t been addressed in any regulations, court cases, or IRS guidance.
Prior to taking this position, it will be prudent to work closely with your tax advisors and potentially obtain a private letter ruling from the IRS.
Establish the Right Team
QSBS requires a multidisciplinary team to evaluate the benefits available under this generous tax provision and to carefully address the complexities. The right players may include advisors specializing in corporate income tax, estate and trust law, and state and local tax.
If you have the stock and can assemble the right team, however, this game of QSBS baseball can be very rewarding.
We’re Here to Help
If you have questions about QSBS, please contact your Moss Adams professional. For information on tax planning, please see our tax-planning guide and year-end insights.