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Don’t Guess and Mess When Planning with QSBS

Oct 19, 2021 | Podcasts

“Don’t Guess and Make a Mess with QSBS,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Travis Hayes, ACTEC Fellow from Naples, Florida. Today, we will hear about how clients should be planning with qualified small business stock, also known as QSBS, and how the proposed legislation being discussed in Washington, D.C. could affect that planning. To discuss this topic, you’ll be hearing, today, from ACTEC Fellow Justin Miller of San Francisco, California. Welcome to Justin.

Thank you very much, Travis. So, as Travis mentioned, today I’ll be covering just a brief overview of qualified small business stocks, QSBS, and I’m also going to touch on the proposed legislation that we’re seeing right now, that as of at least mid-October 2021, and how it might impact that planning. So, let’s just start. Qualified small business stock, QSBS, or, if you really want to impress your friends at a cocktail party, you can call it “Section 1202 stock” because that’s the section of the Internal Revenue Code that covers QSBS. So, what is it?

What is QSBS?

Well, let’s just start from the very beginning, a very quick overview. QSBS provides a benefit for the greater of $10 million–or 10 times basis, whichever is more, to be excluded from capital gains – greater of $10 million–or 10-times basis. So, if you are a founder or an executive or an investor in a qualified small business, it has got to qualify–we’ll get to that in a second. It is a tremendous tax benefit. It is the greatest thing since sliced bread for small businesses. Now, how does it work? Where does it come from?

Now, the original rule came out in 1993, went all the way through to February 2009, and provided a 50 percent exclusion. Now, focus on that 50 percent number because I’m going to come back to that at the end. That is where the legislative proposal, right now, in mid-October 2021, is proposing to go back to. But the original 50 percent exclusion said the greater of $10 million- or 10-times basis, half of that amount is not subject to tax. The other half is subject to tax. And not only that, it is subject to tax at the rate that was in effect back in 1993, which is a 28 percent rate.

So effectively, you’d be paying a tax on 50 percent of a 20-year percent rate, which means you’re basically paying about a 14 percent tax. But it doesn’t end there. With the 50 percent exclusion, it means you’re also subject to AMT because it gets added back as an AMT preference. You’re also subject, to the part that’s taxable at least, to the 3.8 percent net investment income tax, so an additional 3.8 percent surtax there. And, if this proposed legislation passes, you also may be subject to that additional three percent surtax that has been proposed. So, the 50 percent exclusion is good, it’s just not as great as what happened in the more recent years. So, in 2009, the exclusion percentage was increased to 75 percent, and then, again, quickly thereafter, for everything that you acquire the QSBS on or after September 28, 2010, you get a 100 percent exclusion. That means, if you’ve acquired the stock, whether you’re the founder, the executive, the investor – if you’ve acquired it after September 27, 2010, 100 percent of the first $10 million–or 10 times basis, completely excluded from taxes. You have no AMT issue, no 3.8 percent investment income tax. As I said, the greatest thing since sliced bread, if you qualify.

What are the Rules?

Now, not everyone qualifies. There are a bunch of rules. They’re all under Section 1202, and we start with: you have to have a C corporation. Now, there are some rules. Let’s say you start as an LLC or a partnership and you convert to C corporation, may even be possible with an S corporation. But to have it qualify, it has got to be stock from a C corporation, and you have to have received that stock directly from the issuing company. So, you can’t just buy it from a third party, or someone can’t just individually sell it to you. You’ve got to get it directly from the issuing company, so that means a founder, an executive, or somebody investing in the early stages. Now, it also can mean you got it directly from the company if you get it from one of those people, by a gift or inheritance. So, we’re going to get to trust planning that qualifies under these rules. It’s as if you got it from the original person. You kind of tack on that holding period and you tack on their qualifications.

There are some other rules. It has got to be a small business. That means gross assets cannot exceed $50 million through the time you actually receive the stock to the time when the stock was issued. So, that means, if you’ve got an executive, in 2012, and they exercise some options or some restricted stock – the restrictions lapsed or whatever it was, they got their stock in 2012 while it was under $50 million – it did not exceed $50 million – that is qualified small business stock.

Now, let’s say, the next year, a whole big capital infusion comes in. They do another series round. It exceeds $50 million. From that point on, whatever stock they get will not be qualified small business stock. So, you look at the point. When you want to time it is: when did you get those shares and stock? When did you get it? And, was the C corporation, were the assets $50 million or less at that time? So, that’s the rule. Now, there’s nothing you have to file. The company doesn’t file anything. There’s no special, e.g., 83B, election that you have to alert anyone to. You either qualify or you don’t qualify. And oftentimes, a lot of executives, founders, they don’t even realize they have QSBS until a really good group of advisors comes in and starts planning with them and says, “Hey, when did you get the stock? What were the gross assets at the time? You don’t want to miss out on this benefit.”

Are There Other Qualifications?

A few other qualifications. Not only that $50 million number, but it has got to be a special type of what’s called a qualified trade or business, and the company has to use 80 percent of its assets actively conducting that qualified trade or business. So, there’s a whole bunch of exclusions, like banking and finance, insurance, farming, mining, restaurants, hotels, even professional services.

Once again, lawyers, doctors, accountants, are completely excluded from the QSBS benefit. The other requirement is you have to have held the stock for at least five years. Now, if it’s gifted to a trust, you get to use the holding period of whoever gifted it. So, if I held it for three years and I put it in a trust for my kids – a non-grantor trust – that trust has to hold it for only two more years. You have got to make that five-year requirement to get the exclusion, greater of $10 million–or 10-times basis.

Now, what happens if you’re four years and six months in and someone offers you an insane amount of money for your shares? You’re having a big liquidity transaction. You don’t make the five-year period. Well, there is an ability – it’s a different code section 1045–that says you can roll over your qualified small business stock into replacement qualified small business stock. You only have to hold it – you get to tack your holding periods so you’d only have to hold it for another six months to make that five-year period and then get the entire greater of $10 million- or 10-times basis excluded.

In fact, you can even start up your own qualified small business stock. So, if you have six months to go, and you’re willing, and it’s going to be a legitimate business and you do all the crossing your T’s and dotting your I’s, and you want to start your own qualified small business with a C corporation, you can do that. It better be legitimate. But, if you change your mind in a year or two and you decide: “Oh, it didn’t work out,” and you want to take all your money back out, as long as it was a legitimate transaction at the time and it wasn’t replacement qualified small business stock, you can meet your five-year holding period. That’s QSBS in a nutshell, qualified small business stock.

What are the Best Tools?

Now, how are people planning with it, or how should you be planning for it, or how do you really leverage this exemption? And the reality, for the world of trust and estate planning, when you think about children and grandchildren, non-grantor trusts are the way to go with qualified small business stock. Now, don’t get me wrong. Non-grantor trusts have advantages, especially if you’re in a high-tax state like, let’s say New York or California, where you want to set it up in a non-grantor trust jurisdiction. Let’s say a place like Delaware, Alaska, Nevada, South Dakota. Not only no state income tax, but better asset protection. Non-grantor trusts have advantages. In fact, with the proposed legislation, non-grantor trust could become even more popular in the future. But where it really shines – and we’ll talk about the rules before the proposed legislation – is with qualified small business stock planning because every non-grantor trust you set up gets its own greater of $10 million- or 10-times basis exclusion.

So, I’ll quickly walk you through a hypothetical, and then we’ll talk about the proposed legislation. So, hypothetical would be, let’s say, you’ve got a client. The client has three children. The client has a $10 million exclusion. Let’s say an original founder or executive has $10 million of QSBS, that’s the only amount that that individual can take advantage of. We’re not going to get into the debate whether it applies for each spouse or only one for both spouses, but there is some question there. But let’s focus on non-grantor trusts. So, you’ve got an individual who can only take advantage of the one person’s $10 million exclusion but has $11.7 million of exemption amount right now – the use-it-or-lose-it exemption.

So, that individual can set up – let’s say that individual has three children – three non-grantor trusts. Let’s assume we split it equally. $3.9 million in a non-grantor trust for each child. Set up in a state like Delaware, so let’s assume no state income taxes, asset protection, used up your exemption amount, great gift and estate tax planning, but also great income tax planning–because let’s say, eventually, this company’s going to go public next year.

It’s going to more than double in value. Not only does the individual get a $10 million exclusion, but each one of those three trusts will get its own $10 million QSBS exclusion. So, that means, instead of just saving $10 million completely tax free, in this case, the family, as a whole, saves $40 million. The individual and those three non-grantor trusts each get their own $10 million exclusion. Not only that; let’s say the individual is in California, subject to a 13.3 percent tax. So that individual has to pay $1.3 million in California taxes. Each of those non-grantor trusts located in a tax-free state doesn’t necessarily have to pay any California taxes. Now, this is going to be subject to sourcing rules and throwback, but it’s a non-grantor trust, so let’s assume these are contingent beneficiaries. We’re putting this non-grantor trust in a tax-friendly state, and this is really important for states like California that do not recognize QSBS at the state level.

Now, you might say, “Why stop at three? There’s three children. Why not do 10 of these trusts or 50 or 100? What about these really big transactions? Let’s set up as many trusts as we can.” There is a limitation. Section 643F will treat two or more trusts as one trust if you have substantially the same grantor and beneficiaries and your principal purpose is avoidance of tax. So, if it starts to look too similar, these non-grantor trusts, and sometimes people use the term stacking. If you start doing too many of these and they start to look too similar, you may not be able to treat these as separate trusts under 643F.

What are the Proposed Changes?

We do have final regulations under 643F that came out in February 2019, but all they really do in the regulations is repeat the code section. What was scary is the original proposed regulations that came out in 2018 were going to presume that your principal purpose was avoidance of tax unless you can show there was no way you could’ve done this without getting a significant tax benefit. Fortunately, those proposed regulations did not make it into the final regulations. As of now, we don’t have a lot of clarity on what makes it a multiple trust. When do you fall into the 643F rule. And unfortunately, you can’t get a private letter ruling. The IRS and treasury came out – revenue procedure 2021-3. They’re not going to give you any comfort. The IRS said, “We’re not going to give you a ruling on multiple trusts under 643F.” That just came out January 2021.

So, that’s where we kind of are right now, except for these proposed rules from the House of Representatives, the proposed reconciliation bill (HR 5376). Here we are in mid-October, what’s going on? So, what’s in the proposed rules? What could pass? We don’t know for sure, but the proposed legislation is buried there right at the end. I don’t know if you guys want to read HR 5376 but, on page 2,213 of 2,466, there is buried in there a rule that says, “After September 13, 2021, you only get the 50 percent benefit if you’re a taxpayer with an adjusted gross income of $400,000 or more or any trust or estate regardless of adjusted gross income.” So, it doesn’t mean that the QSBS benefit disappears, but what it does mean is that you’re going to be limited to the 50 percent benefit as opposed to the 100 percent exclusion. So, it’s still a little bit of a benefit. As I said, you’re paying a roughly 14 percent tax on the greater $10 million–or 10-times basis, but you still have an AMT issue. You still have a 3.8 percent net investment income tax. You might even have that new proposed three percent tax. So, where does that all come from? Can Congress even do this? Well, real quickly, let me just give you a little background.

Why do we Have QSBS?

Why do we have QSBS? Why is it even in the code? So, going back to 1993, the legislative history: this was supposed to be targeted relief for investors who risk their funds in new ventures and small businesses. The QSBS exclusion was supposed to encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing. And the other argument was that small businesses need “patient equity capital.” Now, that was the original exclusion of 50 percent. Why was it bumped up to 75 percent and then 100 percent in 2010? And then, again, that original 100 percent was supposed to be temporary. The Obama administration, in 2015, made it permanent. Now, once again, as we all like to advise our clients and remind other advisors, when Congress says something is permanent, what they’re really saying is it doesn’t automatically expire. But as we know, in the tax world, nothing is permanent. So, why these changes and why do they want to get rid of it now? Now the original rules in 1993 – that was the Clinton administration- 2009, 2010, 2015 is the Obama administration, these were all democratic administrations. Why do the democrats want to get rid of this now? I’ll give you the three tax-policy reasons.

Why Change it?

First, it’s an expense. The nonpartisan joint committee on taxation, their most recent report estimates a $1.8 billion cost just for 2021 for the qualified small business stock tax expenditure. So, when you start adding that up and think about spending in a proposed reconciliation bill of $3.5 trillion, they’re looking for as much tax savings as they can, meaning more tax revenue for the government to offset the cost of spending in the reconciliation bill. And, by the way, that’s just the joint committee on taxation estimate, it’s very likely a lot more expensive because those estimates are based on pre-September 27 or 28, 2010 QSBS data because of the AMT preference and how it was reported.

The second policy reason, i.e., why get rid of it, is because the largest share of QSBS benefits likely go to very wealthy venture capitalists, founders, early employees of high-growth companies. In other words, getting rid of this QSBS exclusion goes along with the general house theme of taxing people who have adjusted gross income of $400,000 or more because that’s who’s mostly benefitting from this exclusion.

And the third tax policy reason is a question of whether it actually even works; and the answer is nobody really, really knows. I mean, there is the debate, and you could say, “Look, Steve Jobs and Bill Gates, they certainly didn’t have a QSBS benefit, but they went ahead and started companies.” So, would founders still start companies without this QSBS benefit? But even more importantly, what about the people investing in these companies? Would they still invest, or would they invest as much if they didn’t get this tax benefit? We don’t really know. The Congressional Research Service reported in 2016, there is no conclusive evidence in 2016 that the provision has had the intended effect of increasing the flow of equity capital to eligible firms.

But then again, there’s no conclusive evidence that it hasn’t worked, so we just don’t really know whether it’s worked or hasn’t worked. Which brings me to my final comment, and that is, can Congress really do this? Let’s remember that the provision in the tax code, the internal revenue code specifically said, “Look, if you start this company, if you invest in this company back after September 27, 2010, we will exclude 100 percent of your first greater of $10 million or 10-times basis.” This was a promise in the code. This is what got people, arguably, to start businesses or at least invest in these businesses. Can you take it away retroactively? Remember, people have already done these transactions. 

When Would the Changes Take Effect?

Now, we know Congress could certainly say, “Going forward, starting in 2022, you’ll only get a 50 percent exclusion.” But what about the people that’ve already been making these investments for the past 11 years? Maybe the only reason they did that and take that excessive risk with a small business is because they thought they would get the better tax treatment.  Can you really take that away retroactively? And, unfortunately, the answer might be yes.

To put it in perspective, for instance, in 1993, President Clinton and the administration in that time, retroactively increased tax rates in August of ’93, going all the way back. So, if you had an individual that, let’s say, sold something for short-term gains – stock in January of ’93, they were only paying a 31 percent tax, and then they discovered in August of 1993, that they’d have to pay a 39.6 percent tax. Certainly, you can raise taxes retroactively. And I’ll leave you with even the Supreme Court, in 1994 – the Supreme Court, in 1994, unanimously upheld a retroactive repeal of the tax deduction. This is the U.S. v. Carlton case in the Supreme Court, and what the court said in that case is that tax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.

So, could this QSBS benefit at least get cut in half, if not more, with the 50-percent exclusion, and could it be done retroactively? Unfortunately, the answer might be yes. Now, will it be? Will it actually happen? As of at least mid-October 2021, we don’t know for sure, but this has been proposed. Until we have certainty, we at least need to be familiar with some of the planning techniques, assuming this does not go forward in the final legislation. And with that, I hope this was helpful to you, and I hope you all have a great day. Thank you. 

Thank you, Justin, for the timely discussion of QSBS planning and the potential effect of proposed legislation on that planning.

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