There is a little-known part of the tax code called section 1202, which allows for the exclusion of capital gains from taxation for a specific type of small business stock. Founders of companies who have held their corporate stock for at least five years (along with various other guidelines), have been able to eliminate the taxability of their embedded profits when their companies are eventually sold.
This blog is not intended to review the qualifications for Qualified Small Business Stock (QSBS) treatment, but rather, to expand upon how the tax benefits can be utilized. Consult with your tax professional and estate planning attorney in regard to your situation prior to any investment decisions.
Based on when the original qualified small business (QSB) shares were issued dictates the tax exclusion benefits a stockholder may receive. The capital gains tax exclusion ranges from 50% up to a 100% tax exclusion. The most powerful part of this strategy, however, lies within what is called the “QSBS multiplier effect.” Normally, there is a limitation of $10 million (M) in aggregate eligible gains that can be excluded from taxation on QSB stock. Yet, many holders of section 1202 QSB stock have then taken the opportunity to “stack” or multiply that benefit many times over.
Say you had original issue QSB founder stock from 2011 with a cost basis of one penny. The company was sold in 2021 and your shares were valued at $50M. $10M of the QSB shares were cashed out in the deal and $40M in acquirer stock of the new company was received (with carryover QSBS basis). Based on the year those shares were originally issued (post-9/27/2010), 100% of the capital gain on the first $10M in cash received would be excluded from taxation that tax year.1
You would now have another $40M in carryover QSBS to strategize with. If this remaining QSB stock is then made by completed gift to multiple “taxpayers,” they can each have a separate $10M cap gains exclusion. Hence the term “QSBS multiplier effect” – a $10M benefit multiplied into a $50M tax benefit.
You, being a QSB founder stock owner, could then complete gift transfers in a variety of ways to avoid taxation. Here are three examples:
There are various risks to consider and qualifications to be met with QSBS when implementing these types of complex estate planning structures. They must be designed very specifically by a knowledgeable estate planning attorney and well understood by an experienced tax CPA to ensure the QSBS multiplier effect is maintained.
So, if you are considering these concepts for your financial plan, make sure to consult a Certified Financial Planner® in coordination with your tax professional and estate planning attorney. If you are looking for a dedicated San Diego Financial Advisor, be sure to contact Dowling & Yahnke Wealth Advisors today to learn more!