Qualified small business stock: Gray areas in estate planning

One of the most substantial tax breaks for noncorporate taxpayers today is the federal income tax exclusion available upon the sale of qualified small business stock (QSBS). A sought-after tax break for early-stage investors and a welcome if not unexpected windfall for many founders and entrepreneurs, Sec. 1202 provides that if a noncorporate taxpayer sells QSBS issued after Sept. 27, 2010, the first $10 million of gain (or 10 times basis in the stock, if greater), is 100% excluded from federal income taxation.¹ Thus, a sale of $10 million of QSBS represents $2.38 million² in federal tax savings, compared with a $10 million gain realization on the sale of non-QSBS stock.

Originally enacted in 1993, the Sec. 1202 exclusion has become more valuable in recent years for several reasons. First, the original statute provided for only a 50% exclusion from income taxation. The exclusion was then expanded to 75% in 2009 and then to its current 100% exclusion in 2010. Second, in 2017, the law known as the Tax Cuts and Jobs Act (TCJA)³ reduced the corporate income tax rate from 35% to 21%, making C corporations more attractive, given the previously high corporate income tax rate. As a result of those changes and increased interest from investors seeking out QSBSeligible investments, many practitioners report that certain companies have strategically chosen to incorporate (thus making their stock eligible for QSBS status), whereas they might previously have preferred a passthrough structure (which is not eligible for QSBS treatment).

Despite the rising attractiveness of Sec. 1202.compliant structures, a lack of clarity remains around a number of issues regarding QSBS. There are few IRS rulings and little case law on this topic, leaving much room for debate and potential IRS scrutiny of positions taken on tax returns reporting the sale of QSBS. However, due to the above changes that have heightened interest in the exclusion, focus on QSBS and related issues has increased among tax professionals, with a particular emphasis on ensuring that companies are specifically structured to meet Sec. 1202’s requirements. Although statistics are hard to come by, there likely has been a large uptick in taxpayers reporting Sec. 1202 gain exclusion starting around 2022 (five years following the enactment of the TCJA).

With an increase in taxpayers claiming QSBS gain exclusion will come increased IRS attention and, hopefully, increased guidance on the IRSfs positions regarding some of the areas in which the law is still unclear or unsettled. The expected upcoming focus on these issues leaves tax advisers open to risk as they navigate issues with unanswered questions and make tax reporting decisions without official IRS guidance. This article aims to highlight some of the gray areas and provide suggestions for how to mitigate the risk of IRS scrutiny in those circumstances.

QSBS qualification overview

The requirements of Sec. 1202 are simple in text but nuanced in practice. To qualify for the benefit, the following minimum requirements must be met:

• The company must be a domestic C corporation;⁴
• The company, during substantially all of the seller’s holding period for the stock, must meet the active business requirement;⁵
• The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued;⁶
• The stock must have been received at original issuance;⁷ and
• The stock must have been held for more than five years prior to the sale.⁸

Ambiguities arise in the application of these seemingly straightforward requirements to common scenarios.

5-year holding period

The five-year holding period starts from the date the stock was issued to the taxpayer.⁹ Less clear, however, are the consequences when the taxpayer receives something other than stock, such as convertible debt or stock options, or when the business is structured as a non-QSBS-qualifying entity (such as a partnership) that later converts to a QSBS-qualifying C corporation.

The relevant date is the date stock is issued, and the important thing to note is that the company must be a qualified small business with gross assets below $50 million at the time of stock issuance. For convertible debt, that date is the date the debt converts to equity. If an entity is initially formed as a partnership or limited liability company (LLC) , the holding period will start from the date of conversion to the C corporation. For stock options, the five-year holding period does not begin to run until the date the individual exercises the option and receives stock. Thus, a situation could arise in which the company was QSBS-eligible on the date the options were issued but no longer QSBS-eligible at the time the options were exercised. This may put pressure on an employee to exercise a stock option before the employee is ready. Also, for the unwitting employee, holding on to a stock option for too long may result in the potential loss of QSBS eligibility.

Further uncertainty arises with the application of Sec. 1202 to situations that were not contemplated when the statute was drafted or enacted. For example, it has become popular for newly formed companies to issue a simple agreement for future equity (SAFE) in exchange for a cash investment. A SAFE is an agreement whereby an early-stage investor contributes funds to a startup or founder in exchange for the right to receive future equity (typically as part of a future fundraising round). While a SAFE has characteristics of convertible debt in that it converts to equity in the future, it is not a debt instrument. Likewise, while it shares characteristics with equity, it is not clearly equity at the time of issuance. SAFE investors typically prefer their interests to be treated as equity, and therefore the standard SAFE agreement provides that the instrument is to be characterized as stock and, more specifically, common stock for purposes of Sec. 1202.¹⁰

However, the IRS has yet to provide guidance on the tax treatment of SAFEs. And because SAFEs cannot be cleanly categorized as either debt or equity, it is unclear when the taxpayer’s QSBS holding period begins: the date of the SAFE or the date of the subsequent equity issuance. Due to the lack of guidance, accountants and practitioners may differ on their level of comfort with reporting the SAFE as equity. In practice, a priced funding round tends to occur within a company’s first year, often shortly after the SAFEs are issued, so there is likely not a significant difference between the date of the SAFE and the date of equity conversion. However, a taxpayer’s advisers should be sure to consider these issues and take a coordinated position well in advance of any sale. If circumstances permit, the conservative approach would be to delay, if possible, any sale to five years following the issuance of equity following the SAFE conversion event.

Stacking

Ample estate planning strategies leverage the benefits of Sec. 1202, and most center around maximizing the number of individuals and entities eligible to claim the up-to-$10-million federal gain exclusion on sale. This strategy is typically referred to as “QSBS stacking,” and, while it can provide the opportunity for significant tax savings, it is not without risk.

When QSBS is gifted, the stock retains its QSBS qualification as well as the original holding period of the transferor.¹¹ When the recipient sells the stock, they are able to claim their own up-to-$10-million exclusion from capital gains tax. Thus, stacking QSBS exclusions generally consists of gifting QSBS to one or more family members and/or irrevocable trusts treated as nongrantor trusts, each of which is eligible for a QSBS exclusion from gain on a sale of the stock. This technique is efficient when the value of the stock is low (i.e., close to the initial formation of the business), such that gifts of stock use relatively little of the donor’s estate and gift tax exemption amount.

The unsettled question for the practitioner is, “How many trusts are too many?” There is no bright-line rule, but Sec. 643(f) provides that two or more trusts are treated as one trust if (1) they have substantially the same grantor and primary beneficiary, and (2) a principal purpose of such trusts is the avoidance of tax.¹² In 2018, the IRS issued proposed regulations including an anti-avoidance provision “to prevent taxpayers from establishing multiple non-grantor trusts or contributing additional capital to multiple existing non-grantor trusts in order to avoid Federal income tax, including abuse of section 199A.”¹³

The proposed regulations presumed a principal purpose of avoidance if the trusts resulted in a significant income tax benefit that could not have been achieved without the creation of the separate trusts (such as the income tax benefit created by stacking trusts holding QSBS). However, the presumption of tax avoidance did not make it into the final regulations, leaving practitioners with little guidance as to what the IRS considers abusive regarding the number of separate trusts created to multiply QSBS exclusions. Further, the IRS will not provide a private letter ruling to determine whether two or more trusts shall be treated as one trust for purposes of Subchapter J of Chapter 1, Estates, Trusts, Beneficiaries, and Decedents.¹⁴

Because of the lack of guidance, the most conservative approach when setting up multiple nongrantor trusts is to ensure that none of the trust beneficiaries overlap (i.e., each trust is solely for the benefit of a separate family member). However, as a practical matter, many practitioners feel comfortable with an additional “pot” trust that may have beneficiaries overlapping with the single-beneficiary trusts and therefore advise that clients create a trust for each child (or sibling, if appropriate) as well as a pot trust for all descendants. As an additional precaution, it is advisable to document the nontax purposes for forming each trust as well as any steps taken to treat each trust as separate and independent from any other. Prudent actions may include the appointment of different trustees and varying the distributions made from each trust.

INGs and CRTs

Many clients interested in maximizing the benefit of stacking multiple trusts also consider the creation of an incomplete gift nongrantor trust (an ING, but also commonly known as a DING, when formed in Delaware, or NING, when formed in Nevada) and/or a charitable remainder trust (CRT). INGs and CRTs are both considered separate taxpayers from the grantor for income tax purposes, but transfers to an ING or a CRT are incomplete gifts for transfer tax purposes, so their funding does not require the use of the donor’s lifetime exemption. While no clear guidance exists, under the anti-abuse rules discussed above, both an ING and a CRT should be considered sufficiently distinct from other trusts established for the benefit of members of the grantor’s family, and each should consequently be entitled to an additional QSBS exclusion. Both types of trusts, however, raise some unresolved income tax questions.

Certain states, such as California and New York, have cracked down on the use of INGs for state income tax avoidance. California and New York treat all INGs established by state residents as grantor trusts, decoupling from the federal income tax treatment of these trusts. Opinions differ on whether gain on the sale of QSBS owned by an ING established by a New York resident will be subject to state income tax. The relevant New York statute requires a taxpayer to add to their New York taxable income any income earned by an incomplete nongrantor trust “to the extent such income and deductions of such trust would be taken into account in computing the taxpayer’s federal taxable income if such trust in its entirety were treated as a grantor trust for federal tax purposes.”¹⁵

If the ING were a grantor trust for federal tax purposes, of course, it would not qualify for its own $10 million Sec. 1202 exclusion separate from the donor’s exclusion, so New York may seek to impose income tax on the gain from a sale of QSBS owned by an ING to the extent that it exceeds the taxpayer’s remaining individual Sec. 1202 exclusion. On the other hand, many practitioners take the position that the application of the New York law requires federally taxable ING income to be added back to the taxpayer’s New York taxable income base. Since the sale of QSBS by an ING will not incur federal income tax (up to the relevant gain exclusion threshold), there is nothing to add back, and no state income tax will result. New York has not offered guidance on whether gain incurred on a sale of QSBS by an ING that is excluded from federal income tax will be subject to New York income tax, and practitioners differ on their reporting positions.

Charitable remainder trusts are income-tax-exempt charitable entities. Thus, a sale of QSBS by a CRT produces no taxable income at the trust level. However, distributions to the noncharitable beneficiaries of the trusts carry out taxable income. The character of the income distributed to the noncharitable beneficiaries is determined through the rules of Sec. 664(b). In general, distributions are deemed to consist of property carrying with it the highest income tax burden (ordinary income first, followed by capital gains, and finally other/exempt items of income). Where and how excluded Sec. 1202 gain fits into this ordering system is unclear.

While the tax benefits of INGs and CRTs are attractive, it is important to stress to the client that while the planning techniques can bring exceptional tax results, the law is unsettled, and there is a risk that the IRS or state taxing authority could challenge the QSBS tax outcome.

Spouses

Perhaps the most common unresolved question regarding QSBS is whether spouses filing jointly are eligible for two exclusions or whether they must share one exclusion. Anecdotally, a majority of tax advisers believe that while the answer may be unclear, the more conservative approach is that spouses are eligible for one aggregate QSBS exclusion (the greater of $10 million or 10 times basis), regardless of whether they file jointly or separately.

The text of the statute itself is unclear. Sec. 1202 specifically refers to “a taxpayer other than a corporation.” A taxpayer means “any person subject to any internal revenue tax,”¹⁶ which indicates that each spouse should be eligible for his or her own exclusion. In addition, Sec. 1202(b)(3) provides that in the case of a separate return by a married individual, paragraph (1) (A) shall be applied by substituting “$5,000,000” for “$10,000,000.” It is clear that if a married couple file separate returns, they will each enjoy only a $5 million exclusion from gain, half the amount of other taxpayers. The negative implication of this section is that if a married couple are filing jointly, each spouse should be eligible for his or her own exclusion. However, the section goes on to provide that in the case of a joint return, the amount of QSBS gain is to be allocated equally between the spouses for purposes of applying the above subsection to subsequent years.¹⁷ Many advisers have interpreted this provision to mean that even married couples filing jointly should be eligible only for a single exclusion, leading to conflicting approaches among accountants, attorneys, and other tax advisers.

Some accountants take the view that there is a reasonable basis to take the position that a married couple filing jointly are eligible for two exclusions and therefore feel comfortable signing a return that reports them as such, despite the uncertainty. Others will sign a return only if the position is disclosed, or not at all. Some practitioners believe that two exclusions are available only if QSBS is owned as community property or held separately by each spouse. Given the ambiguity, there may be a benefit to splitting the QSBS ownership between the spouses and deciding how to report a sale at a later date; after all, it is possible the IRS might provide more clarity in the following five years and prior to a sale, or the accountant may have additional experience based on later audits or other learning. If the stock is held by each spouse, it can be sold quickly when needed, and a decision as to how to report the sale can be made at a later date.

Transfers of QSBS

In order to be eligible for QSBS status, the stock must be acquired by the holder at the stock’s original issuance either in exchange for money and other property (but not other stock) or as compensation for services rendered.¹⁸ There are limited exceptions to the original-issuance requirement, however, preserving QSBS status in the hands of a transferee if the transferee acquired the stock by gift, at death, or in a qualifying partnership distribution.¹⁹ If a transferee acquired the stock pursuant to one of these permissible transfers, the transferee is treated as having acquired the QSBS in the same manner as the transferor (i. e., at its original issuance) and as having held the QSBS for the same period as the transferor. Thus, a transferee does not need to independently satisfy the five-year holding period for gain exclusion.

Neither the statute nor the regulations define what qualifies as a transfer of QSBS “by gift.” A gratuitous transfer from the original holder to another individual or to a grantor or nongrantor trust should preserve QSBS status. Other common estate planning transfers, such as a sale to a grantor trust or a substitution of assets in or out of a grantor trust, are more ambiguous. One could argue that because all transactions between a grantor and a grantor trust are disregarded for income tax purposes, there is no transfer of QSBS when it is contributed to or removed from the grantor trust within the meaning of Sec. 1202. If there is no transfer to begin with, there is no need to meet the exception for transfers by gift.

Conversely, one might argue that a transfer “by gift” refers to transfers recognized under Chapter 12 of the Internal Revenue Code. In the gift tax context, neither a sale to or from a grantor trust nor a transfer pursuant to an exercise of a grantor trust substitution power would qualify as a transfer by gift. Because Sec. 1202 is an income tax provision, it seems most consistent to define “transfer” in the income tax context as a transfer between two different taxpayers. Under this reading, QSBS could be freely transferred between a grantor and a grantor trust by sale or substitution. Similarly, a transfer or sale of QSBS between two different trusts that are grantor to the same individual should also preserve QSBS status because there has been no change from an income tax perspective in the taxpayer owning the stock.

In the context of nongrantor trusts, a straight gift of the stock from the original holder to the trust clearly constitutes a transfer by gift and preserves QSBS status for the stock owned by the trust. The QSBS consequences of other transactions, including a decanting to a different nongrantor trust, would hinge on whether the decanting constituted a transfer (which, in turn, implicates whether the new trust is considered a different taxpayer) and, if so, whether a decanting can plausibly be considered as a transfer “by gift.” Similar considerations arise in the case of a distribution of QSBS from a trust pursuant to a power of appointment.

Ambiguity also arises when QSBS is held or transferred indirectly through a single-member LLC (SMLLC) or other entity. So long as the SMLLC is disregarded from an income tax perspective, it should not matter if the QSBS is owned directly or through the entity, as the taxpayer should be treated as directly owning the SMLLC’s assets for all federal income tax purposes. If interests in the LLC are transferred in a way that causes the LLC to be treated as a partnership for income tax purposes, however, QSBS status would be lost.

Less clear is the outcome if QSBS is contributed by the original holder to an SMLLC and 100% of the LLC ownership is then gifted to a nongrantor trust. For income tax purposes, this should be indistinguishable from a straight gift of the QSBS from the grantor to the nongrantor trust, and many practitioners treat it as such. However, some practitioners have questioned whether the transfer of LLC membership interests constitutes a gift of the underlying QSBS that preserves the exception under Sec. 1202(h), or whether it is a transfer of an entity, negating any QSBS benefits post-gift. If the facts and timing allow, a taxpayer could consider retitling QSBS in the taxpayer’s individual name and gifting The QSBS directly. The recipient family member or trust could recontribute QSBS to an LLC if preferred.

Supporting a position

In all circumstances, when it comes to QSBS, the best line of defense is to ensure a coordinated approach among the client’s tax advisers in advance of any tax planning or sale. In some circumstances, proactive discussions may help identify risks and necessitate changes in ownership structure or sale of the stock, while in others the discussions may lead to engaging counsel with deeper expertise in this area. In all cases, exploring the issues upfront ensures that the advisory team is informed of the proposed planning and that there are no surprises or inconsistent philosophies among advisers when it comes time to report the various positions.

Another defensive strategy is to seek a legal opinion from an attorney that might support the intended position. If the attorney can reach a certain level of conclusion, that opinion may help limit potential liability in the case of an audit or a reassessment by the IRS.

Finally, if the facts are extraordinarily unusual or the potential tax implications are sufficiently substantial, the client may wish to request a private letter ruling from the IRS, unless the relevant question is one on the IRS no-rule list. While obtaining a private letter ruling is not an inexpensive or quick endeavor, the letter ruling will provide the client with a black-and-white answer to their particular situation and ensure any gray area is clarified.

Footnotes

¹Qualified small business stock issued after Aug. 10, 1993, and prior to Sept. 28, 2010, may be eligible for a partial gain exclusion.

²Assuming 20% federal capital gains tax plus 3.8% net investment income tax.

³P.L. 115-97.

⁴Sec. 1202(d)(1).

⁵Sec. 1202(c)(2). Generally, to meet the active business requirement, at least 80% (by value) of the company’s assets must be used in the active conduct of one or more qualified trades or businesses, and the company must be an eligible corporation. The definition of qualified trade or business excludes many service-oriented and other businesses (Sec. 1202(e) (3)). See also Andersson, “Qualified Small Business Stock Exclusion: Who’s Eligible?” 52 The Tax Adviser 684 (November 2021).

⁶Sec. 1202(d)(1)(A); note that the $50 million limit is on gross assets of the company, not a limit on the valuation of the business.

⁷Sec. 1202(c)(1)(B).

⁸Sec. 1202(a)(1).

⁹In some cases (such as a gift), even if it is transferred to another taxpayer, the recipient will get to “tack” on the original owner’s holding period (Sec. 1202(h)(2)(A)).

¹⁰The typical SAFE agreements promulgated by startup accelerator Y Combinator provide that “[t]he parties acknowledge and agree that for United States federal and state income tax purposes this Safe is, and at all times has been, intended to be characterized as stock, and more particularly as common stock for purposes of Sections 304, 305, 306, 354, 368, 1036 and 1202 of the Internal Revenue Code of 1986, as amended” (Y Combinator, Safe Finance Documents, sample agreement, “Post-Money Valuation Cap,” Section 5(g)).

¹¹Sec. 1202(h)(2)(A).

¹²For purposes of Sec. 643(f), spouses are treated as one grantor.

¹³Preamble, REG-107892-18.

¹⁴Rev. Proc. 2023-3, “Areas in Which Rulings or Determination Letters Will Not Be Issued,” §3.01(90).

¹⁵N.Y. Tax Law §612(b)(41).

¹⁶Sec. 7701(a)(14).

¹⁷Sec. 1202(b)(3)(B).

¹⁸Sec. 1202(c)(1)(B).

¹⁹Sec. 1202(h).

Contributors

Arielle Lederman, J.D., LL.M., is a senior client adviser and wealth strategist with AdvicePeriod in New York City. Heather D. Casteel, J.D., is a partner with Accelerant Law PLLC in New York City. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

Articles

McCartney, “Tax Practitioner Issues Related to Sec. 1202 Exclusion Reporting” 53-12 The Tax Adviser 9 (December 2022)

Andersson, “Qualified Small Business Stock Exclusion: Who’s Eligible?” 52 The Tax Adviser 684 (November 2021)

Veniskey, “Investments in Qualified Small Business Stock,” 51 The Tax Adviser 791 (December 2020)

Podcast episode

“The Value of Qualified Small Business Stock (QSBS) Treatment,” AICPA PFP Section podcast (Nov. 3, 2023)

CPE self-study

Tax Planning for Small Businesses — Tax Staff Essentials

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