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Mastering QSBS Packing

Article highlights:

  • Unlock Tax Savings: Discover the power of QSBS packing, a strategy designed to help investors maximize their tax savings on qualified small business stock investments.
  • Simple and Effective: Explore two straightforward QSBS packing methods that can significantly increase your basis in QSBS assets, leading to greater annual exclusions and tax savings.

Qualified Small Business Stock offers significant tax benefits for investors in eligible small businesses. By understanding the QSBS exemption and employing strategies like QSBS packing, investors can increase their asset basis and save on taxes. In this guide, we will explain QSBS packing, the QSBS exemption and various ways to ‘pack’ QSBS investments to maximize tax savings.

Understanding QSBS and the QSBS Exemption

QSBS refers to stocks issued by small C corporations that qualify under Section 1202 of the Internal Revenue Code. To be considered a Qualified Small Business (QSB), a company must have gross assets not exceeding $50 million before and immediately after the stock issuance.

The QSBS exemption allows investors to exclude a portion or all of the capital gains from the sale of QSBS from federal income tax, provided certain criteria are met:

  1. The stock must be issued by a C corporation meeting QSB requirements.
  2. The investor must acquire the stock directly from the corporation at its original issuance or through a qualified intermediary.
  3. The investor must hold the stock for at least five years before selling.

Demystifying QSBS Packing

QSBS packing is a strategic approach investors use to increase the basis of their QSBS shares and maximize their QSBS exemption. The key rule that QSBS packing is built around is the limit on the amount you can claim in QSBS exemption is the lower of:

  1. $10 million: This is the absolute maximum amount you can exclude from your capital gains for any single company’s QSBS.
  2. 10x your investment: This refers to ten times the adjusted basis of your investment in the QSBS. For example, if you invested $3,000,000 in a qualified small business, you could potentially exclude up to $30 million (10 x $3,000,000) in capital gains from federal income tax and in most states.

Its important to know these limits apply on a per-company basis, so you can potentially claim QSBS exemptions for multiple companies, each with its own limits. Now how does this tie to QSBS packing?

There are two primary methods for QSBS packing:

  1. Contributing Cash or Property in Exchange for QSBS Shares In this approach, an investor contributes cash or assets worth more than $1 million to the issuing corporation in exchange for QSBS shares. As a result their QSBS exemption will be for 10x their investment, or more than the $10 million

How does this work?

Step 1: An investor invests $4 million of cash in a C corporation.

Step 2: The investor’s basis for the annual exclusion calculation is determined by referencing the FMV of the assets contributed, which is $4 million.

Step 3: The increased basis of $4 million allows the investor to exclude up to $40 million (10 x $4 million) in capital gains from taxation.

  1. Selling the same stock with High-Basis and Low-Basis grants in the Same Tax Year: This method involves selling QSBS stock with a low basis (or grant price) during the same tax year the investor sells another bat of the same stock with a high-basis. The goal is to increase the total basis of QSBS sold during the taxable year, as the annual exclusion calculation is determined by reference to the total basis of QSBS stock sold during the year, regardless of whether each grant is currently eligible for exclusion under Section 1202.

How does this work?

Step 1: A founder sells half of their stock for $40 million that has a basis of $5,000 and would only be able to exclude $10 million with QSBS.

Step 2: The founder sells another grant of the same stock with a high-basis during the same tax year, such as from the exercise of stock options where they paid $2 million for the stock.

Step 3: The total basis of QSBS sold during the year is now $2.005 million ($5,000 original basis + $2 million from stock options).

Step 4: The increased total basis of $2.05 million allows the founder to exclude up to $20,050,000 in federal capital gains taxation

By using this strategy, the founder effectively doubles their Section 1202 exclusion by packing their basis, taking advantage of the annual exclusion rather than just the $10 million exclusion.

Conclusion

QSBS packing is a powerful strategy for investors seeking to maximize their tax savings when investing in small businesses. By understanding the QSBS exemption and employing QSBS packing methods, investors can increase their basis in the assets and benefit from substantial tax savings. It is essential to consult with a qualified tax professional when implementing these strategies to ensure compliance with tax laws and regulations. The step-by-step examples provided above illustrate how QSBS packing works in practice, helping investors make informed decisions about their investments and tax planning.

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