Excluding capital gains of $10M — or more — from taxes with QSBS

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 a guide to qualified small business stock by Aaron White, the chief growth officer of Pleasanton, California-based Adero Partners. 

The potential strategies explained by White and other experts working with startup founders and investors could enable some clients to multiply the tax advantages. And the exclusion — first enacted during President Bill Clinton's administration at a 50% rate then boosted to the full 100% during President Barack Obama's tenure — hasn't drawn as much criticism or calls for reform as other tax avoidance methods.

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 Section 1202 of the Tax Code can avoid paying capital-gains taxes on the greater of $10 million or 10 times their investment. Only the "opportunity zone" credits from the 2017 Tax Cuts and Jobs Act come close to generating the same level of savings, White said.

"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 another guide to QSBS by startup investing and growth platform Carta. 

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 a briefing on the method by tax attorneys with the Hanson Bridgett law firm. For example, $10 million worth of stock in the new C corporation would carry an exclusion of up to $100 million.

"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. Leaving one state for another with different tax rules, considering a multiyear liquidation of the stock in the future and executing some form of a rollover or exchange for shares in another company could open the door to further savings.

"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."