Who Doesn’t Like Tax Free Capital Gains?

QSBS & The Entrepreneur

In this age of start-ups and founders everyone is looking for an edge. Smart tax planning can be one. There are a lot of tools in the tax planner’s kit; some however, less well known and utilized than others. One device that can be quite powerful when capitalizing a business but, in our experience, falls under the category of “less well known” is Qualified Small Business Stock (QSBS)¹. It can also be used as a compelling way to attract and retain talented employees in highly competitive markets. If you are not familiar with it, the following can serve as a primer, and if you are, perhaps a good refresher.

The Background

Congress created QSBS in 1993 to promote the flow of capital to emerging small businesses, which are universally acknowledged to be critical drivers of innovation and job creation. It accomplished this by creating an incentive for non-corporate taxpayers to invest in them. When the requirements for issuance and subsequent sales of these shares are met, 100% of up to $10m of realized capital gain (or ten times basis if greater) is excluded from federal (and some states²) income tax. Nor are those gains subject to the AMT or NIIT.

Rules of the Road

A company must be a domestic C corporation. The QSBS stock must be acquired directly from the company in exchange for money, property or services³. Importantly, it must be held for more than five years before sale. And the company must, at all times prior to and immediately after the taxpayer acquires the shares, have had gross assets of $50M or less⁴. During “substantially all” of the time since the issuance of stock it must also have been engaged in the active conduct of a “qualified trade or business,” which means utilizing 80% or more of the value of its assets in those endeavors. These essentially comprise manufacturing, retailing, wholesaling and technology, as opposed to service industries such as, health, law, athletics, financial services, insurance etc. as well as farming, mining and drilling.⁵

Planning Strategies:

QSBS Exclusion Stacking. This technique usually entails the gifting of QSBS to irrevocable non-grantor trusts for the benefit of family members, although it can be to any taxpayer. A non-grantor trust is a trust that is a taxpayer with its own tax ID number. This works because when gifted it retains its QSBS status, and the holding period of the person making the gift⁶. So, for example, if an entrepreneur gifts half his shares to a trust for the benefit of a child and after five years both his and the trusts shares are each worth $10m, both may sell them income tax free using their respective $10m exclusions.

There is also an issue of how many separate trusts with commensurate $10m exclusions can be established. The IRS says that two or more trusts will be treated as one if they are too similar in terms and have tax avoidance as a principal purpose⁷. If that were the case then only one exclusion would be available. There are ways to draft around this issue, but care must be taken, and knowledgeable counsel engaged.

This is also a much more effective technique when the gifting is done while the QSBS share prices still have low values, as the gifts will be taxable and require the use of lifetime gift and estate tax exemptions. And while largely beyond the scope of this article it is worth noting that Charitable Remainder Unitrusts (CRUTs) and Incomplete Gift Non-Grantor Trusts (INGs) should be entitled to additional QSBS exclusions while, at the same time, not requiring use of the grantor’s lifetime exemption.

Enhancing Employee Equity Participation Plans. Many start-ups also use equity participation plans to attract and retain talented employees. These plans include Qualified & Non-qualified Stock Options (ISOs/NSOs) restricted stock and Restricted Stock Awards (RSAs). Combining these plans with QSBS shares can meaningfully supercharge them. And while stock options are generally exercisable only upon vesting, many startups allow early exercise, meaning the shares can be purchased but are not transferable until the actual vesting date.

The secret sauce, of course, is taking full advantage of the QSBS income tax exclusion. Assuming the company is qualified, the tolling of the five-year waiting period is the critical factor. For options the waiting period begins when they are exercised, even if not yet vested. For restricted stock and RSAs it begins when granted. And in all cases an 83(b) Election must be filed with the IRS to start the clock running⁸. A 83(b) Election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of equity grants at the time of granting, rather than vesting. It makes sense to do so when the value of the equity is currently low but expected to increase substantially over time.

As we are focusing on entrepreneurs and startups, an important question is begged. What if the new company is sold or merged before the 5-year holding period has expired? In that case, it is the 1045 Rollover⁹ to the rescue! This allows the owner of QSBS stock, who has held it for over six months, but not the full five years, to – within 60 days of the transaction – rollover the gain into new QSBS eligible stock and retain the basis and holding period of the original shares. As a creative extension of this use case, imagine a founder who, having already sold $10m in value of QSBS shares from her company’s IPO, still owns additional shares that have been held for more than five years. These could be sold at any time to invest in new QSBS with no tax consequence and, if done so within 60 days of that sale, a new $10m exclusion should be available to her.

Conclusion

Qualified Small Business Stock can be a powerful tool for entrepreneurs to raise capital and attract and retain top talent. Having said that, its application is more nuanced than it might at first seem. Always engage qualified counsel when exploring it.

1. IRC Section 1202
2. For example, NY and CT do, while CA and NJ do not.
3. Generally, it cannot be acquired from another person.
4. As opposed to the company’s valuation, which is not limited. And after the issuance of the stock it may grow over this level without affecting the QSBS status.
5. Satisfying this test can require complex analysis which is beyond the scope of this article.
6. Sec 1202(h)(2)(A)
7. Sec 643(f)
8. This will result in a level of ordinary income taxation in the year of exercise equal to the then existing spread on the options and the value of the restricted stock.
9. Sec 1045 – Rollover of gain from qualified small business stock to another qualified small business stock.

About Fieldpoint Private

Fieldpoint Private is a boutique private banking firm established at the onset of the financial crisis by 31 individuals including former Chairmen and CEOs of some of the most well-known and successful financial and consumer firms in America. Their intent was not to craft a firm that would emulate the large, established institutions, but to serve as an alternative. Dedicated to meeting the comprehensive financial needs of highly successful individuals, families, businesses and institutions, Fieldpoint Private offers a powerful combination of private personal and commercial banking services directly and in partnership with our clients’ most trusted advisors. In 2021, Fieldpoint Private founded Fieldpoint Private Trust, increasing the breadth of capabilities available to serve our clients in both sole trustee and co-trustee capacity.

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