The attractive capital gain exclusion for QSBS can often be maintained when a company is purchased for new equity in the acquiring company. If a QSBS holder receives new non-QSBS shares from an acquisition after only a 3-year holding period, then the $10 million exemption is maintained within the new shares. That said, any subsequent growth in the new shares wouldn’t qualify for QSBS.
QSBS Stacking Strategy
A unique feature of QSBS is that the $10 million capital gain exemption is per tax payer. When a QSBS holder transfers some of their shares to another person or trust, the recipient becomes eligible for their own separate $10 million capital gain exemption. The recipient also inherits the original holder’s holding period.
As an example, if a shareholder is issued QSBS on 1/1/20 and three years later their child inherits the stock, they will inherit the original holding period as well. Further, if the inherited stock is sold three years later on 1/1/26, then they would be eligible for the $10 million capital gain exemption.
Combining the separate tax payer feature and holding period carryover features of QSBS can be lucrative. For instance, a QSBS holder may have $14 million in stock eligible for a $10 million capital gain exclusion. If that stock holder were to give 25% of their shares to a child (or a trust with the child as beneficiary), 25% to another child, and 25% to their parent, then each of the recipients would have $3.5 million of stock and a $10 million capital gain exemption. Collectively, they would have a capital gain exemption of $40 million if the company had a liquidity event.
Founders should work with their CPA, financial planner, and other advisors when implementing the stacking strategy to avoid running afoul of IRS rules on multiple trusts. Section 643(f) indicates that multiple trusts may be treated as a single trust if the grantor and beneficiaries are substantially the same and the primary purpose of establishing the trusts is deemed to be tax avoidance. In other words, setting up ten trusts to get $100 million of capital gains exclusion for three children isn’t likely to pass muster.
While trusts provide enhanced asset protection and greater control on distributions, founders should think through the pros and cons of direct gifting or QSBS stacking through trust structures. Trusts have additional ongoing costs, administrative requirements, and potentially higher compressed tax rates on the reinvestment.
Those considering the stacking strategy should keep the lifetime gift exemption in mind. While the exemption is set at $13.99 million in 2025, the 2017 Tax Cuts and Jobs Act is scheduled to expire in 2026, reducing the exemption to approximately $7 million. In an effort to lower future potential capital gains, an entrepreneur may find themselves in a situation where they end up paying current gift tax by exceeding the lifetime exemption.
The timing of gifts should also be carefully considered. In the case where the company is worth more over time, early gifts can use less of one’s lifetime gift exemption. Given the cost and administrative hassle of implementing trust gifts, many shareholders opt to make these gifts close to a sale. However, if a sale is too close to the timing of the gift, the IRS may argue the “assignment of income” doctrine and potentially disallow the gift.
Stacking strategies can be combined with other effective financial planning strategies to help minimize potential tax liability. The founder may want to consider gifting sharing to non-grantor trusts in tax-free states to avoid state taxes on the sale and/or reinvestment. Moreover, stacking gifts of minority interests can benefit from valuation discounts to minimize the use of the lifetime gift tax exemption.
QSBS Packing Strategy
Another strategy to potentially reduce future capital gains and increase one’s basis is to contribute cash or property in exchange for shares. The increase in basis would reflect the market value of the property or cash contributed on the date of contribution. Contributing $2 million of property would then allow a capital gain exemption of $20 million given the higher of 10X basis or $10 million rule. However, these new shares would be subject to a new holding period to satisfy the 5-year requirement, and shareholders should be mindful of the $50 million aggregate assets limitation post issuance of these shares.
Another way to effectively use the “packing” QSBS strategy is to sell both high and low basis tranches of stock in the same year. For example, a founder could sell $36 million worth of shares in two equally valued tranches. One tranche of $18 million was purchased for $10,000 and eligible for a $10 million capital gain exclusion. The second tranche was purchased by exercising stock options for $3 million. The basis for both tranches is $3,010,000, so the capital gain exclusion is $30,100,000. By utilizing this strategy, the capital gains would be $5,900,000.
