If you hold a share in a Qualified Small Business Stock (QSBS), you may be entitled to beneficial tax exclusions of up to 100% of your gains. This incredible opportunity is sometimes overlooked by investors and advisors who are unaware of the various methods suited to increase gain exclusions. But discussing adequate QSBS tax planning strategies with an advisor could help investors take these amazing opportunities and capitalize on them even further.
QSBS: What You Need to Know
QSBS exemptions were created to encourage investment in small businesses by giving investors the opportunity to avoid tax on a portion or all of their gain. QSBS allows shareholders to exclude up to the greater of $10 million in gains less any of the $10 million previously excluded, or 10x the shareholder’s tax basis in the company.
Before you can capitalize on the benefits of the QSBS gain exclusions, you must first meet their requirements:
- The company must be a domestic C corporation
- The company must not have more than $50 million in assets
- The acquired stock must have been originally issued by the company
- Stock must be issued by a corporation that uses at least 80% of its assets in an active trade or business
- The holding of the stock must be for at least a five-year period
- If you are granted stock options, then the five-year holding period doesn’t start until you exercise
- If you are granted restricted stock, then the five-year holding period doesn’t start until you vest or make an 83(b) election
- The stock must have been issued by a corporation after August 10, 1993
- Corporate redemptions may disqualify the status
How to Maximize Your Gains: Per-Issuer Limitations
The QSBS gain exclusion applies benefits on a per-taxpayer (also known as per-issuer) basis. Each taxpayer holding a QSBS in a small business is required to separately apply the gain exclusion up to the per-issuer maximum gain exclusion cap. So, each taxpayer that sells QSBS in a company will be entitled to either the $10 million cap or the 10x basis cap.
This is great news for investors, and one way in which you can take advantage of this clause is by “stacking” the per-issuer limitation.
Stacking refers to dividing an issuer’s QSBS among multiple taxpayers. As the eligible QSBS gain exclusions ($10 million or 10x basis) apply to each respective taxpayer who sells QSBS, increasing the number of taxpayers who hold the stock will increase the total excludable gain.
There are various ways to stack your QSBS, including presenting family members with the opportunity to acquire stock from the corporation in early financing rounds; gifting your stock to family members outright; or gifting your stock to various non-grantor trusts for the benefit of family members. You can also designate multiple beneficiaries of the QSBS in your estate plan to potentially increase the excludable gain.
Another planning opportunity that would allow you to maximize your excludable gains from the sale of QSBS is “packing.” Packing refers to maximizing your excludable gain by taking advantage of the 10x basis limitation.
There are a few ways to pack your stock holdings to increase your basis, including:
- Acquire Additional Stock
The 10x basis limitation applies to all of your stock in a QSBS company, and not just stock that is QSBS eligible. Exercising options can increase your basis that can be used as a 10x multiplier to exclude gain from the sale of other QSBS eligible stock.
- Contribute Property to the Corporation
Property contributed to a corporation in exchange for stock provides a shareholder with tax basis equal to the fair value of the property contributed. This can be especially valuable to the founder of a start-up company that contributes intellectual property in exchange for stock.
If a taxpayer sells the QSBS before the five-year holding period is up, the taxpayer is not necessarily out of luck! There is some leniency in the form of a 1045 rollover. The opportunity for gain exclusion is still available to the taxpayer and the holding period from the acquisition of the original QSBS is retained as long as the proceeds from the sale of QSBS are reinvested in a replacement stock that meets QSBS requirements.
You have your QSBS—now what? Proper planning with your tax adviser can allow you to preserve generational wealth and maximize your tax savings from the sale of QSBS beyond what you ever thought possible.