We are now more than 18 months into the Jobs Act and given the nature of the pro-business tax environment today, it’s time for practitioners to dust off their Internal Revenue Code books and take a fresh look at IRC Sec. 1202. There may be significant benefits available for taxpayers invested in qualified small businesses – or, more specifically, Qualified Small Business Stock (QSBS).
Background
Section 1202 was enacted in 1993 as an incentive for taxpayers to start and invest in certain small businesses. Congress was looking to spur entrepreneurs and investors to commit capital to early-stage private companies. Investors were given an incentive on the back end – that is a U.S. federal income tax capital gain exclusion applicable to the sale of QSBS. Depending on when the stock was acquired, an investor could exclude from 50% up to 100% of the gain. In essence, IRC Sec. 1202 allows a taxpayer to exclude 100% of the eligible gain realized from the sale or exchange of QSBS issued after September 27, 2010 and held for more than five years. Gain on the sale of QSBS of up to the greater of $10M or 10 times cost basis could receive preferential tax treatment.
This is why you should care about IRC Sec. 1202. Let me reiterate the previous concept: you can exclude from capital gains taxation the greater of $10M or 10 times the taxpayer’s aggregate adjusted tax basis. For example, if the taxpayer’s adjusted basis is $15M, as much as $150M could be eligible for exclusion. It appears this limitation applies per-issuer, which affords an investor the ability to take advantage of the exclusion for multiple QSB stockholdings. Further, this is a per taxpayer exclusion.
So for clients engaging in estate planning, the question becomes: can a taxpayer stack up these exclusions in QSBS by using trusts to hold the QSBS? The dictates of the Code and the tax literature seem to indicate this is possible.
Basic Requirements
A QSBS may generally only be issued by a “qualified small business” within the meaning of IRS Sec. 1202. This is generally a C corporation which has aggregate gross assets under $50M. The business may not be in an excluded industry. Most technology, life sciences and venture-backed operating companies should meet the qualified small business test. Excluded industries are: law, accounting, banking, insurance, financing and other businesses where the principal asset is the skill and knowhow of its employees. It’s important to note that the asset requirement ($50M) is measured when the corporation qualifies as a QSBS, not when the taxpayer sells the stock. Therefore, the QSB can be a growth stock and the taxpayer can benefit from capital gain exclusion upon sale.
To qualify, an owner of QSBS must be a non-corporate taxpayer and must have received the stock at original issuance. The taxpayer must hold the shares for five (5) years or longer.
The ownership requirements and attendant benefits for an investor in a QSBS might seem pretty straightforward. However, can the benefits for your savvy client be enhanced through some tried and true estate planning techniques, such as contributing the QSBS to non-grantor trusts?
Some QSBS investors are investigating ways to maximize the $10M exclusion by “stacking up” additional QSBS exclusions through gifting the QSBS to trusts. For example, an investor acquires QSBS and subsequently gifts it to several irrevocable non-grantor trusts for the benefit of family members (e.g., children, grandchildren, siblings). Can the non-grantor trust – a separate taxpayer – claim its own $10M QSBS exclusion? The theory is that each non-grantor trust has its own $10M exclusion. Unfortunately, there is no clear or controlling guidance on this issue, but it seems to make sense based on the Code.
If a taxpayer gifts or bequeaths QSBS, the recipient of the QSBS will also be allowed to tack QSBS eligibility and the holding period under Section 1202(h)(2)(A) and (B). A transferee who acquired QSBS by gift or at death is treated as having acquired the stock in the same qualifying manner as the transferor and tacks the transferor’s holding period.
It seems consistent that a similar result should apply if the gift had been made originally to an irrevocable grantor trust whose grantor status terminated prior to sale of QSBS.
When drafting the estate plan, practitioners should consider that, if the end game is to maximize the QSBS gain exclusion, the grantor could make gifts to separate non-grantor trusts for the benefit of various family members instead of making a gift to a single trust or “pot trust.” Use of separate trusts allow for maximization of the number of separate taxpayers who seemingly can claim the $10M gain exclusion. For example, if a client sets up four (4) separate non-grantor trusts for his children and contributes QSBS stock to each trust, as separate taxpayers the trusts could theoretically claim their own separate exclusion, thus resulting in potentially $40M in gain exclusion (4 x $10M per non-grantor trust).
If a decedent passes along his or her QSBS at death, the QSBS receives a step-up in basis under IRC Sec. 1014. However, note that QSBS appreciation after death would continue to be eligible for gain exclusion under IRC 1202. Because of the gain exclusion and gain rollover aspects of QSBS, taxpayers may wish to consider transfers of these assets during their lifetime to remove them from their gross estate. This is because beneficiaries may not benefit as much from a step-up in basis due to the gain exclusion of QSBS, and QSBS status can be retained and transferred through lifetime gifts to donees. This presents planning opportunities using non-grantor gift trusts.
Now assume that an individual owns originally-issued QSBS and subsequently makes a gift of QSBS to one or more irrevocable trusts that are separate taxpayers (non-grantor trusts). The question becomes whether a non-grantor irrevocable trust may claim its own $10M QSBS gain exclusion, separate from the grantor’s $10M gain exclusion. This question appears to be answered in the affirmative. As set forth above, per IRC Sec. 1202(h)(2), the transferee of QSBS obtained by gift or bequest is treated as having acquired the stock in the same manner as the transferor and can tack the transferor’s holding period. The same result should apply if the gift was originally made to an irrevocable trust structured as a grantor trust for income tax purposes, but the grantor trust status was terminated prior to the sale of the QSBS.
Another interesting opportunity for gain exclusion may present itself with the recent promulgation of the rules for Qualified Opportunity Zones (QOZs) in the 2017 Tax Act. The QOZ rules allow for deferral and partial forgiveness of capital gain that is reinvested in a QOZ. The rules also exclude from gross income subsequent appreciation of QOZ investments under certain conditions. This presents an interesting opportunity for investors in QSBS. Depending on how Congress reconciles the incentives for QSBS with the incentives for QOZs, the tax advantages of investing in QSBS may be enhanced if the QSBS is treated as meeting the requirements of QOZ stock. The enhanced benefit could result in permanent exclusion of gain on the subsequent sale of QSBS stock. We’ll have to wait and see how Congress reconciles these incentives and if forthcoming QOZ regulations allow for this enhanced benefit.
If you have any questions or would like more information, please contact Kevin Lenhard at kjl@kjk.com or 216.736.7226, or reach out to any of our Wealth & Estate Planning professionals.
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