The provisions of Qualified Small Business Stock (QSBS) found under IRC Section 1202 are inarguably complicated to navigate. There are several aspects to consider when it comes to gifting QSBS. The stock donor and beneficiary will want to ensure that the QSBS gifting specifications are followed with total accuracy to guarantee that the profitable gifted stock doesn’t become a long-term legal or financial burden for either party.
Timing is Everything
The first key aspect to consider when giving and receiving QSBS is timing. If done correctly, timing can be the difference between saving millions of dollars versus paying tax on the gifted stock. Gifting of QSBS is allowed under Section 1202(h)(1) and can greatly benefit the donee of the QSBS. The donee will become the recipient of the QSBS in the same manner in which the donor received the stock. Additionally, the QSBS recipient will be seen to have held such stock for the same period of time the donor held it — also referred to as “tacking on.”
However, there is a possibility that there will be a tax placed on the gifted QSBS if the IRS finds that the donor has gifted QSBS in an “anticipatory” manner (i.e. gifting said stock after signing a merger agreement with another corporation). This is known as the “Assignment of Income Doctrine.”
What is the Assignment of Income Doctrine?
To get a broad concept of an “Assignment of Income Doctrine,” we should first look at West’s Tax Law dictionary that states the doctrine:
“[T]reats gratuitous transfers of income as ineffective for the purpose of shifting income. The transferor is taxed when the transferee receives the income pursuant to the transfer. Sometimes referred to as the anticipatory assignment of income doctrine.”Assignment of Income Doctrine, West’s Tax Law Dictionary § A3170 (updated Feb. 2022).
This doctrine also taxes income to individuals who have created an interest “to receive it and enjoy the benefit of it when paid.” Helvering v. Horst, 311 U.S. 112, 119 (1940). A prominent case, Commissioner v. P. G. Lake, Inc., decided by the Supreme Court, stated that if a taxpayer is “entitled to receive at a future date interest on a bond or compensation for services, makes a grant of it by anticipatory assignment, he realizes taxable income as if he had collected the interest or received the salary and then paid it over.” Comm’r v. P. G. Lake, Inc., 356 U.S. 260, 267, 78 S. Ct. 691, 695, 2 L. Ed. 2d 743 (1958).
When is the Doctrine Triggered?
There is not yet a definitive answer from the IRS or the Tax Court on what exactly triggers a gift to fall under the “Assignment of Income Doctrine.” However, it appears that it is very fact-specific to the case at hand. In Palmer v. Commissioner, 62 T.C. 684, 693 (1974), the Tax Court held that mere anticipation of redemption does not trigger the “Assignment of Income Doctrine” if the taxpayer were to gift assets before the redemption was to be agreed upon.
As a result of the Palmer case, the IRS followed Palmer’s analysis for the “Assignment of Income Doctrine” by creating Rev. Rul. 78-197, 1978-1 C.B. 83 (1978). Which states if the facts of the case purport to have a charitable contribution followed by a prearranged redemption plan, then the income will not be considered to fall under the “Assignment of Income Doctrine.” In Palmer, the shareholder gifted stock to a charitable foundation that the shareholder also had some control over. The next day, the shareholder then had the charitable foundation, the donee, arrange the redemption of the stock — hence the “prearranged redemption” plan.
Learn more about the details and intricacies of gifting QSBS under Section 1202 here.
However, the doctrine will be triggered if a taxpayer agrees to a merger then gifts his shares to a donee. As a result, the donor will be held liable to pay taxes upon the gift. See Est. of Applestein v. Comm’r of Internal Revenue, 80 T.C. 331 (1983). Legally, this can be classified as avoiding tax liability. In this circumstance, the taxpayer was legally bound by the merger agreement, and there was no prearranged plan to gift such assets.
Future Planning for Gifting of QSBS
As seen in these court rulings, as long as the taxpayer has prearranged the gifting of QSBS with donees (other than spouses) before a known exit event, the “Assignment of Income Doctrine” is unlikely to come into play. QSBS gifting should occur before the QSBS holder enters a sales agreement or has reason to know of the acquired qualified business. As stated previously, the QSBS tax exemption could be multiplied if a taxpayer, in good faith, plans on distributing his assets to others through gifts. However, taxpayers need to navigate a fine line if the company they hold stock in is approaching a transaction.
Are you planning or preparing to gift QSBS stock, or are you the recipient of QSBS eligible stock? Our team of QSBS experts here at CapGains.com can assist you in navigating the nuances of QSBS qualifications and ensure QSBS eligibility of your stock over time.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.