CI Dowling & Yahnke Tax Planning

Qualified small business stock: Maximizing your tax benefit

Nobody wants to pay more income tax than they need to, so it’s always valuable to find ways to reduce the tax burden. There’s a little-known part of the tax code called Internal Revenue Code section 1202, which allows for the exclusion of capital gains from taxation for a specific type of small business stock.1 Founders of companies who have held their corporate stock for at least five years (along with various other guidelines), have been able to eliminate the taxability of their embedded profits when their companies are eventually sold. 

How may Internal Revenue Code 1202 benefit you?

This blog is not intended to review the qualifications for Qualified Small Business Stock (QSBS) treatment, but rather, to expand on how the tax benefits can be utilized. Before making any investment decisions related to QSBS, consult with your tax professional and estate planning attorney (and other specialists, as required).

The tax exclusion benefits a stockholder may receive is based on when the original shares of the qualified small business (QSB) were issued. The capital gains tax exclusion ranges from 50% up to a 100% tax exclusion.2 The most powerful part of this strategy, however, lies within what is called the “QSBS multiplier effect.” Normally, there is a limitation of $10 million (M) in aggregate eligible gains that can be excluded from taxation on QSB shares.3 Yet, many holders of Internal Revenue Code section 1202 QSB shares have then taken the opportunity to “stack” or multiply that benefit many times over.

QSBS multiplier effect: An example

Let’s say you had original issue QSB founder stock from 2011 with a cost basis of one penny. The company was sold in 2021 and your shares were valued at $50M. We’ll assume that $10M of the QSB shares were cashed out in the deal and $40M in acquirer stock of the new company was received (with carryover QSBS basis). Based on the year those shares were originally issued (post-9/27/2010), 100% of the capital gain on the first $10M in cash received would be excluded from taxation that tax year4.

You would now have another $40M in carryover QSBS with which to strategize. If this remaining QSB stock is then made by completed gift to multiple “taxpayers,” they can each have a separate $10M capital gains exclusion. Hence, the term “QSBS multiplier effect” – a $10M benefit multiplied into a $50M tax benefit.

You, being a QSB founder stock owner, could then complete gift transfers in a variety of ways to avoid taxation. Here are three examples: 

  1. Make a completed gift transfer of $10M to irrevocable trusts for each of your children (in this example, two children), who in turn would each receive the $10M capital gains tax exclusion upon the future sale of the stock.
  2. Gift $10M to a Charitable Remainder Trust (CRT) that, along with receiving a partial tax deduction for contribution, may also potentially receive an exclusion of capital gains income upon future CRT quarterly income distributions.
  3. Choose to gift the last $10M to a non-grantor trust domiciled in a zero-income tax state. The future stock sale could be free from income taxation at the federal level and the state level, and potentially have asset protection measures as well.

The bottom line

When implementing these types of complex estate planning structures, there are various risks to consider and qualifications to be met with QSBS. They must be designed very specifically by a knowledgeable estate planning attorney and well understood by an experienced tax CPA to ensure the QSBS multiplier effect is properly maintained.

So, if you’re considering these sophisticated tax-mitigating concepts for your financial plan, make sure to consult a Certified Financial Planner® in coordination with your tax professional, estate planning attorney, and CI Private Wealth financial advisor.

 

1 https://www.law.cornell.edu/uscode/text/26/1202
2 https://www.law.cornell.edu/uscode/text/26/1202
3 https://www.law.cornell.edu/uscode/text/26/1202
4 https://www.journalofaccountancy.com/issues/2013/nov/20138431.html


ABOUT THE AUTHOR

Matthew R. Adams, CPA, CFP, CDFA

Matthew R. Adams, CPA, CFP, CDFA

Partner, Wealth Advisor

Matt joined Dowling & Yahnke Wealth Advisors in 2017. He holds the CERTIFIED FINANCIAL PLANNER™ (CFP®), Certified Public Accountant (CPA), and Certified Divorce Financial Analyst® certifications. Matt completed his undergraduate work at UC Santa Barbara where he majored in Business Economics and Accounting, graduating cum laude. He was also an intercollegiate men’s volleyball scholar athlete at UCSB.

Prior to joining D&Y, Matt spent 15 years in the financial services industry in various capacities. He started his career as a Certified Public Accountant with Deloitte, a global accounting firm, where he worked in their San Diego, Sydney, and London offices. More recently, he was a wealth manager at a San Diego-based independent advisory firm.

Matt is a San Diego native. Having grown up in Olivenhain, he now lives in Solana Beach with his wife and their two sets of twins (fraternal girls and identical boys).




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