TRUST & ESTATE PLANNING

How to Take Advantage of the Qualified Small Business Stock Exclusion

10.13.2021 - Amy Ko, Senior Relationship Manager

The Qualified Small Business Stock (QSBS) exclusion allows you to avoid federal income tax on the first $10 million of capital gain when you sell stock in a “qualified” small business.

Under current rules, you can exclude 100% of your gain for stock acquired after September 28, 2010. For stock acquired before that date, a partial exclusion is possible.[1]

Current tax proposals in Washington would limit the QSBS exclusion to 50% of your gain for individuals with at least $400K in Adjusted Gross Income (AGI) and be effective going back to September 13, 2021. While that would cut the current benefit in half for some people, a 50% exclusion remains a significant tax savings for founders, investors and early employees in start-ups and other small businesses.

How do I determine if my stock qualifies?

Your stock may qualify for the exclusion if the company is an US C-Corp with less than $50 million in gross assets. In addition, at least 80% of the firm’s assets must be used to actively run the business—as opposed to making external investments.

Keep in mind that stock in a company that has exceeded $50 million in gross assets may still qualify.  Your stock simply must have been issued before the company reaching the $50 million threshold.

You need to have owned the stock for at least five years. This does not include time when you held an option or note that was later exercised or converted into stock. The five-year countdown begins only after the conversion to equity has been completed.

Also, certain types of service businesses (healthcare providers, legal practices, financial services firms, architects, etc.) and natural resource businesses (farming, mining, etc.) do not qualify for the exclusion. Finally, you must have acquired the shares from the issuing company for either cash, services, or property (including intellectual property).

Multiplying Your QSBS Exclusion

Currently, if you receive qualified stock via gift, death or distribution, you can retain the QSBS exclusion treatment and holding period of the original owner. 

Here’s an example of why this is important. Let’s assume you’re the founder of a startup with qualified stock currently worth $20 million. You have three children for whom you create three separate irrevocable non-grantor trusts and gift $5 million worth of your stock to each (retaining $5 million of stock for yourself). Five years later, the value of your original $20 million of stock soars to $40 million as the result of a cash sale of the company. If you hadn’t gifted any of your stock, you’d be eligible for a $10 million exclusion. But now because you gifted your stock, it’s not just you that is eligible for the exclusion.  The three trusts, as separate taxpayers, are also eligible for their own $10 million exclusions, for a total of $40 million of federal tax exclusion—a quadrupling of your tax savings. What’s more, through the gift you would only use $15 million of your and your spouse’s lifetime gift tax exemptions to effectively transfer $30 million of your wealth.

Of course, any strategy involving an irrevocable trust requires careful planning.  Establishing your trusts in Delaware can enable your family to retain investment control and provide general flexibility to meet your family’s needs. Depending on where you live, a Delaware trust may also provide state tax savings.

7 common pitfalls with QSBS planning

Some of the more common missteps in planning for the QSBS exclusion include:

  1. Not Knowing About It. Many small business owners either aren’t aware of the exclusion or haven’t carefully thought about what they should be doing to maximize their QSBS opportunity. This can have a significant negative impact when it comes time to prepare for an IPO, negotiate financing, or seek out a buyer for the business. If the QSBS asset requirements can be met and you founded your company as an LLC, you may consider consulting with a tax law attorney to convert from an LLC to a C-Corp. 
  2. Company Redemption Risks. Redemptions of more than 5% of the aggregate value of the company’s stock within a year, and redemptions from a related person to the QSBS holder within a two-year window, can disqualify all of the company’s stock from QSBS eligibility. Unfortunately, this can be a common occurrence in small firms where, early on, one of several early employees decides to leave. Rather than wait to a later date, the other employees will use company assets to buy that individual out—inadvertently disqualifying all the company’s stock.
  3. Unintentionally Selling or Gifting Away QSBS Shares. Gifting qualified stock can be a powerful planning technique, but you don’t want to do it unintentionally. For example, gifting QSBS eligible stock to charity can be a major mistake, since the charity does not receive any additional tax benefit and you give up a major tax benefit without any increase in your charitable deduction.
  4. Not Investing Early Enough. For limited partners and other strategic investors, the timing of when you invest in a venture fund can directly impact whether you participate in earlier QSBS eligible portfolio company investments. As you evaluate the timing of your investments, you should consider the tax benefits that could come with participation in a fund’s QSBS eligible companies. 
  5. Assuming Your Business Does Not Qualify. Eligibility for the QSBS exclusion is not always a clear determination in relation to the nature of a business. For example, while a traditional financial services or healthcare firm would not qualify for the exemption, a FinTech or Biotech start-up very well may. Always consult with a tax expert before assuming your company qualifies or doesn’t.
  6. Delay in Exercising Stock Options. Even if they’re aware of the QSBS exclusion, many start-up employees mistakenly assume the 5-year clock begins when their options vest. As described above, the required holding period doesn’t actually begin until the options are exercised. This can upset your financial plans and increase investment risks with a concentrated stock position.
  7. Missing the Rollover Opportunity if You Do Not Meet the 5 Year Requirement. If you have not met the 5-yr holding period requirement when your stock is sold but you have held it for at least 6 months, you may rollover your gain into stock in another QSBS eligible C-Corp within 60 days to avoid tax on the gain, maintain the QSBS treatment and receive the capital gains exclusion once the full 5-yr holding period has been met.

As mentioned at the beginning, the rules for QSBS may be subject to change but the exclusion looks to remain. With proper planning, the exclusion can still save you several million dollars in taxes even under the current proposals. 

At Fiduciary Trust International, we can guide you through your options to maximize the benefits of the QSBS exclusion and connect you with the experts you will need on your team to ensure the best result for you.  

1 Currently, the exclusion applies up to the greater of $10 million or 10 times your aggregate adjusted income tax basis of the qualified stock sold in the year. Shares acquired prior to February 17, 2009 are eligible for a maximum 50% exemption; shares acquired between February 17,2009 and September 27, 2010 qualify for a 75% exemption.




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