On Jan. 11, 1999, the very first day I began practicing law, the federal estate tax applicable exclusion amount (the exemption) was a modest $650,000 per individual, and the concept of portability between spouses didn’t exist. As a result, the opportunities to apply my fairly new estate tax planning knowledge were plentiful. Every client who had a large life insurance policy, had been a good saver, was a moderately successful professional or owned a profitable business had a need for estate tax planning.
Over the years, the exemption has steadily increased, and with the passage of the Tax Cuts and Jobs Act of 2017, it’s jumped dramatically: The exemption as of this writing is $11.58 million per individual. Further, married couples can share their exemption with one another under the portability rules.1 For most estate planners, the frequency with which we can apply advanced estate tax planning techniques on behalf of our clients has diminished considerably. When one tax planning door closes, however, another one opens. While the change in the law causes less opportunity to use pure estate tax planning techniques, it does give us planners the incentive to serve clients with solid income tax planning options.
One such opening involves ownership of qualified small business (QSB) stock. Under Internal Revenue Code Section 1202, certain taxpayers who acquire original-issue QSB stock and hold it for at least five years may have the ability to exclude some or all of its unrealized capital gains, as well as the associated 3.8% Medicare surtax (that is, net investment income tax (NIIT)). Let’s take a brief look at the details.
What’s QSB stock?
IRC Section 1202 strictly defines “QSB stock.” Here’s an oversimplified summary: First, the issuing company must be a domestic C corporation. Second, the company’s assets can’t exceed $50 million between Aug. 10, 1993 and the date of the issuance of the stock. Third, the corporation must use at least 80% of the company’s assets2 in the active conduct of its business.3 Finally, the company can’t be a personal services business.4
Sale of QSB Stock
Does the sale of all QSB stock qualify for the exclusion of tax on sale? Not all QSB stock can qualify for the sale exclusion. Specifically, under Section 1202:
• The QSB stock must be purchased by or paid to the shareholder as originally issued stock. It can also be received as a gift or inheritance from someone who held it this way. The QSB stock can’t be purchased from a prior owner. Note: The holding period tacks on to the stock if it’s given to/inherited by another person or if the company converts the stock to another class, engages in a stock split or engages in a reverse stock split.
• The QSB stock must be held for at least five years to get the 100% exclusion from tax. If it’s held between one and five years, the gains are treated like any other capital gains and taxed at up to 20%. If held under one year, then the gains are short-term capital gains and taxed as ordinary income.
Assuming the statutory predicates are met, the taxpayer may exclude up to the greater of: (1) $10 million5 less the sum of any gains already taken by the taxpayer for that specific issuer in
previous tax years;6 or (2) 10 times the taxpayer’s adjusted cost basis of QSB stock of the issuer that was disposed of during the same tax year. On the taxpayer’s personal income tax return for the year of the sale, he must file Internal Revenue Service Form 8949 to indicate the QSB stock treatment, as well as indicate it on his IRS Form 1040 Schedule D.
It’s strongly recommended that the shareholder get a formal written certification from the QSB attesting to the fact that the relevant stock was QSB stock. This certification is to be held in case of audit. It’s also recommended that a shareholder maintain sterling documentation showing: (1) when the QSB stock was obtained, (2) how it was obtained (purchase, compensation, gift or inheritance), (3) if purchased, the amount paid, (4) proof of payment, (5) copy of the stock certificate, and (6) a calendar notation showing when the 5-year holding period occurs.
Example of Tax Savings
As stated above, if an owner of QSB stock sells it, up to the greater of $10 million or 10 times the cost basis of the stock can be realized tax-free. Here’s an example that illustrates the advantage of this tax benefit:
• In 2012, Dr. Christopher Client, a talented biochemist, joined a pharmaceutical startup that was a QSB. He purchased or was paid a block of 100 shares of QSB stock for $0.01/share for a total cost basis of $1. The company directly issued the shares. After successful clinical trials and a public offering, Dr. Client’s shares are now worth $20 million. Dr. Client would like to sell the shares but wants to minimize the taxation of the unrealized gains. (Due to the low basis, virtually 100% of the sales proceeds would be taxable.)
• After obtaining a written QSB stock certification from the proper officer of his employer, Dr. Client sells $10 million of his QSB stock and has his accountant complete and file the proper tax forms. Because his basis is $1, Dr. Client is able to exclude the entire amount realized from federal capital gains tax. He avoids $2 million in capital gains tax, and another $380,000 in NIIT, for a total savings of $2.38 million.
The above number shows just how advantageous the possession of QSB stock can be. But, what if Dr. Client wants to use Section 1202 to shelter the gains from the sale of the remaining $10 million of QSB stock that he possesses? Can he do that? The answer is that he can.
Some practitioners might believe that he could transfer his remaining shares to his wife and have her sell them. At first glance, this seems to be a good idea. However, an examination of Section 1202 makes me doubt the prudence of this strategy. The statute7 doesn’t provide that a married couple filing jointly can double the articulated limit, but it does expressly state that a married couple filing separately can’t shelter the greater of $10 million or 10 times basis. Instead, they can only shelter the greater of $5 million or 10 times basis. Thus, it would seem that the spirit of the statute is to hold the ability of a married couple to shelter gains to the limit set in Section 1202(b).
Fortunately, Section 1202(h)(2) allows a separate taxpayer8 to receive QSB stock by gift or inheritance and then enjoy the full amount of the statutory tax exclusion. So, in our example, Dr. Client can give the balance of his QSB stock to a taxpayer other than his spouse, and that taxpayer can get the full exclusion from capital gains and NIIT. Possible recipients could be the children of Dr. Client or irrevocable non-grantor trusts for their benefit. Of course, before recommending such a gift to his client, an estate-planning attorney would be well advised to weigh the estimated income and NIIT to be saved from this strategy against the anticipated estate tax impact that would occur as a result of that gift.
What if Dr. Client would like to get the full QSB stock treatment for his remaining shares without giving them away to another taxpayer? A review of Section 1202(h) shows that Dr. Client could create an inter vivos non-grantor qualified terminable interest property (QTIP) trust for his spouse and then transfer the shares to that trust. The transfer would qualify for the unlimited marital deduction from gift tax under IRC Section 2523. Further, the non-grantor trust could then sell the shares and enjoy the full exclusion from capital gains tax under Section 1202. (In our example, if Dr. Client gave his remaining $10 million in unsold QSB stock to an inter vivos QTIP non-grantor trust for his spouse, and then the trust sold the stock, capital gains tax could be avoided up to the statutory limit.)
Taking the “mile high” view, the client has the opportunity to double the amount of tax savings that he could otherwise enjoy if he kept the stock. In this way, capital gains from Dr. Client could shelter a full $20 million of QSB stock under Section 1202. The total tax benefit would double from the previous figure, going from $2.38 million to $4.76 million in capital gains and NIIT saved.
Immediate Tax Savings
The foregoing discussion shows the tremendous immediate tax savings that planners can help a client with QSB stock obtain on the sale of his shares. In light of the increasing estate tax exemptions, and thus decreasing ability to provide relevant estate tax strategies to our clients, familiarity with powerful income tax planning tools is imperative to planning attorneys looking to remain relevant to their clients.
Endnotes
1. See Internal Revenue Code Section 2010(c)(4).
2. Eighty percent by value. IRC Section 1202(e)(1)(A).
3. Thus, the company can’t be a pure holding company.
4. Per Section 1202(e)(3), companies in these lines of work can’t qualify: “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Further, the trade/business can’t involve banking, insurance, financing, leasing, investing, farming, raising or harvesting trees, the production or extraction of underground resources like gas and oil or the operation of a hotel, motel or restaurant.
5. Or, $5 million for a married taxpayer filing separately. Section 1202(b)(3)(A).
6. Section 1202(b)(1).
7. See Section 1202(b)(3).
8. A “separate taxpayer” is one who doesn’t report income taxes on the same return as Dr. Client. The IRC and Treasury regulations are silent as to whether one can “stack” exclusions using gifts to grantor trusts (such as grantor retained annuity trusts or intentionally defective irrevocable trusts), and I’m aware of no cases that discuss this topic. Not wanting to be a test case, I would be reticent to advise a client to make gifts to a grantor trust to attempt to stack the Section 1202 exclusions.