Qualified Small Business Stock (QSBS) offers business owners significant federal tax benefits of exclusion of up to $10 million or ten times the stock’s basis in capital gains, whichever is greater. The stock must be held for at least five years prior to a sale. This provision not only incentivizes investment in small businesses but also presents strategic opportunities for estate and trust planning.
Understanding QSBS and Its Benefits and Utilizing Trusts
QSBS refers to stock in a qualified small business. The business is typically a domestic C-corporation with gross assets under $50 million at the time of issuance, actively conducting a qualified trade or business. Investors holding QSBS for the requisite period can exclude substantial gains from federal taxation.
One effective strategy to enhance QSBS benefits is using trusts. By transferring QSBS to irrevocable trusts, each trust as a single entity can independently utilize the QSBS exclusion and potentially multiply the total tax-free gain across multiple beneficiaries. This approach is particularly beneficial for high-net-worth individuals seeking to maximize their tax savings and efficiently transfer wealth.
How Does Trust-Based QSBS Planning Work?
When QSBS is gifted to a trust, the trust is treated as the shareholder, and the holding period of the stock tacks onto the trust’s holding period. This allows the trust to potentially meet the five-year holding requirement necessary for the exclusion. Importantly, each trust has its own exclusion limit, providing a means to “stack” exclusions across multiple trusts. Because the QSBS exemption applies on a per-tax payer basis, dividing shares across trusts can multiply the tax-exempt gains. Each trust can take advantage of the exclusion of the greater: up to $10 million or ten times the stock’s basis in capital gains.
Complex trust planning can significantly enhance QSBS benefits, but complexities must be considered:
- Trust Structure: Selecting the appropriate type of trust is crucial. For instance, Spousal Lifetime Access Trusts (SLATs) can be effective, allowing one spouse to create a trust benefiting both themselves and their spouse, thereby maximizing exclusions.
Other types of irrevocable trust agreements benefiting different individuals may also be effective. - Federal Compliance: Ensuring that both the QSBS and the trust meet all legal requirements is vital to preserve the tax benefits. This includes adhering to holding period requirements and ensuring the business qualifies as a small business under IRS definitions
- State Taxes: While federal tax benefits are substantial, state tax treatment of QSBS can vary. It’s important to consult with tax professionals to understand state-specific regulations and potential liabilities.
Example of QSBS Trust Planning
Jane Doe founded a startup and acquired QSBS shares worth $10 million. She anticipated significant growth and created five irrevocable non-grantor trusts, each to benefit a different family member. Two million dollars in QSBS shares was assigned to each trust. After the required five-year holding period, the company, if sold, and the total value of the shares grew to Twenty million dollars.
In this scenario, each trust was a separate taxpayer, and each trust qualified for its own $10 million exemption. Jane thus sheltered the full $20 million in gain from federal taxes.
Conclusion
Integrating QSBS into trust structures offers a powerful strategy for maximizing capital gains exclusions and enhancing estate planning. Given the complexities involved, it is advisable to consult with legal and tax professionals experienced in QSBS and trust planning to tailor strategies to individual circumstances and ensure compliance with all applicable laws. Gift tax considerations must also be considered with careful valuation and exemption planning. And finally, the IRS scrutinizes trust structures that appear to be created solely for tax avoidance purposes. Trusts need to be created with legitimate beneficiaries and serve a genuine estate planning purpose.
To discuss further, contact KJK’s Estate, Wealth, and Succession Planning attorneys, Susan Friedman (SLF@kjk.com) or Christine Sabio Socrates (CSS@kjk.com).
