The capital-gains exclusion for qualified small business stock represents “one of the best individual tax benefits available today,” according to one financial planner.
Financial advisors, tax professionals and their clients may tap into more than a half dozen “planning opportunities” that reap big savings from certain startup investments allowed under the current rules to net up to $10 million in capital gains with no payments to Uncle Sam, according to
The potential strategies explained by White and
While many entrepreneurs and investors and nearly all of the tax professionals and advisors located near Silicon Valley in the Bay Area know QSBS strategies well, White “still meet[s] CPAs and some clients who aren’t as familiar with this,” he said in an interview. Founders, early-stage employees, angel investors and venture capitalists with holdings in C corporations that fit the criteria listed in
“When you look at the individual Tax Code, there are not a lot of ways to avoid or defer tax from a liquidity event,” he said. “For straight capital gains from a stock sale, there really isn’t anything like the qualified small business stock exclusion.”
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The main challenges come from “just identifying the criteria and doing an assessment of the company,” according to White. In general, the owners of the company must have incorporated it as a C corporation in the U.S., the businesses must have $50 million in gross assets or fewer, and, crucially, at least 80% of those assets must be used in a qualified trade or business, according to
The last part rules out the following five types of small businesses, Carta noted:
- “Perform services related to health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, finance, banking, insurance, leasing, investing or brokerage
- Rely on an employee or owner’s reputation (i.e. if it endorses products or services, uses an individual’s image, or has an employee make appearances at events or on media outlets.)
- Produce products, such as fossil fuels, for which percentage depletion (a type of tax deduction) can be claimed
- Operate a hotel, motel, restaurant or similar business
- Are a farming business
If the business falls outside those restrictions, planners and their clients can begin to think through the key logistical questions such as obtaining a form of attestation that the business qualifies, figuring out whether an early-stage employee will need to exercise stock options and preparing to meet the minimum holding period of at least five years. Among other technical hurdles, the stockholders should pay close attention to the entity’s classification, White said.
“It’s very important if you’re setting up a company that the company is not an S corporation,” he said.
On the other hand, launching the firm as a limited liability company before converting it to a C corporation could ramp up the tax savings. Under one provision of Section 1202, the fair-market value of a firm at the time it shifts into a C corporation gives QSBS holders an exclusion amounting to 10 times the basis of their stock, according to
“In other words, if a founder converts an LLC to a C corporation, her basis for purposes of the 10x test is set at the fair market value of the LLC immediately before conversion,” the attorneys wrote. “This gratuitous basis step-up can provide a huge potential exclusion for founders without the need to stack QSBS through gifts and trusts.”
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Advisors and their clients should remember, however, that they will need to pay capital gains taxes for any appreciation in the LLC’s value prior to the conversion and start the clock on the five-year holding period at the time of the entity change rather than the launch, they noted.
Other means of maximizing the tax savings include gifts of QSBS to spouses, children or other family members, with each additional shareholder generating another $10 million in exclusions from capital gains, according to White’s guide. In the latter scenario for non-spousal gifts, advisors and their clients would have to create a non-grantor trust for the transaction.
“Understanding QSBS tax planning is essential for founders, start-up employees, angel investors, and venture capital partners,” White’s guide said. “A wealth advisor with tax expertise can help you identify QSBS and navigate the various rules and planning opportunities.”
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