The implementation of advanced planning strategies to: (1) reduce or eliminate capital gains tax; (2) reduce future estate tax; and (3) increase asset protection from creditors and lawsuits should be on every founder, owner, and investor’s mind. All strategies revolve around time and the amount of equity ownership an employee or investor has in the company. The most relied upon considerations to keep in mind while envisioning planning strategies—to save money on taxes in the long-run are:
- What stage is the company in its life cycle?
- What is the value of your shares?
- What are your current and future wants and needs?
What is QSBS?
Qualified Small Business Stock (QSBS) provides for up to a 100% exclusion of Capital Gains taxes. The QSBS regulations are located in Internal Revenue Code (IRC) Section 1202 and include criteria for both the corporation to qualify as a Qualified Small Business and criteria for the investor to determine how much of their gain may be eligible for tax exclusion.
Gifting QSBS Through an Irrevocable Non-Grantor Trust
While there is a limit on the amount of Capital Gains a taxpayer can exempt under Section 1202, one planning strategy that can maximize return is the gifting of QSBS through an irrevocable non-grantor trust. A founder can gift QSBS to a child or beneficiary through a trust that can qualify for its own Section 1202 exemption.
This type of trust is generally meant for children or future heirs. The original owner of the qualified stock is considered the grantor and when the QSBS is gifted (rather than sold) using the strategy, the stock maintains its QSBS eligibility.
The Benefits of an Irrevocable Non-Grantor Trust
The savings value associated with this type of gift is vast thanks to the federal gift tax exclusion. Created to prevent tax evasion through gifting, the federal gift tax applies to the donor or giver of a large financial gift. The rate for this tax ranges from 18-40% depending on the value of the gift, so it is important for donors to understand the limits of the gift tax exclusion in order to avoid a large bill.
Individual taxpayers can gift $15,000 annually to an individual recipient. This means a donor can give more than this amount, but not to the same person in a single year. Additionally, American taxpayers have a lifetime limit of $11,700,000 as of 2021. Once a donor reaches this lifetime limit, any gifted amounts above this limit will be taxed at a 40% rate.
In order to pass to a recipient the most value, one must consider gifting shares early at a lower valuation— meaning they wouldn’t use up as much of the donor’s lifetime gift limit. However, not all qualified small businesses experience profitable exits, so waiting long enough to be confident that the shares you are gifting will grow in value is also an important consideration.
Additional Ways to Save
Since some states conform to QSBS exemptions and some don’t. While others have zero state income taxes at all. Where you establish your trust matters. Some states, like California, do not observe the Section 1202 exclusion for capital gains while many others do, and states like Nevada and Texas have no state income tax whatsoever. By setting up your irrevocable non-grantor trust in a state that fully conforms to QSBS, you will ensure a maximum exemption for your beneficiaries.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.