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The Qualified Small Business Stock exemption, or QSBS, is the best tax break around. As a result of Congress’s push early in the new millennium to encourage Americans to start something new, founders and owners of early equity in companies from startups to Main Street SMBs can earn up to $10 million in capital gains from the sale of their shares free of federal and most state capital gains taxes. (Sad trombone for residents of California, New Jersey, and the handful of other states that charge tax on QSBS-eligible gains.)
If QSBS is the best deal in the U.S. tax code, then, almost by definition, QSBS stacking is next best. Each individual is limited to one $10 million exemption. But drawing on the insight that every shareholder receives his or her (or its) own QSBS exemption, however, several strategies have arisen that allow individuals and their families to multiply the QSBS benefit — allowing them to avoid taxes on an additional $10 million, $20 million, or more — by giving shares away or placing them in a trust.
How does QSBS stacking work in practice? There are several options available, and each will be a fit for different users depending on their needs.
The absolute simplest way to get an additional QSBS exemption — or several — is to give some shares away. QSBS applies to any shares received directly from the company, which includes original grants and, critically (per IRS guidance), shares gifted from an original recipient. In practice, then, an owner of QSBS-eligible stock who expects to earn more than $10 million from the sale of those shares could give a portion to their child, parent, sibling, friend, or, really, anyone else (possibly excluding their spouse; special rules apply here, and you’ll need to consult an expert about your specific circumstances).
If it’s that easy, why isn’t this always the way? There are three drawbacks to the gifting approach.
The next-simplest approach is also the most common. If the main costs of QSBS gifting are a lack of control — over disposition of the shares and how the recipient receives and spends the money — and a lack of access, then a SLANT is often the solution. Described simply, a SLANT is a trust that you set up and fund (with startup shares, for example), the trust gets its own QSBS exemption, and the named beneficiaries — typically your spouse, followed by your kids — get fairly liberal access to the funds.
If it’s that straightforward, how does a SLANT solve the pathologies of QSBS gifting?
The main drawback of the SLANT approach (other than the overhead and cost, which Valur exists to minimize!) is that the strategy is especially powerful if you act early. The reason is those same estate tax concerns. If you give away your shares when they are worth virtually nothing, then you’ll use up virtually none of your lifetime estate tax exemption. If you wait until the shares have appreciated — say you raise a Series A or B and the 10% of your shares you planned to give away are now valued at $10 million — you’ll have to use up much more (and potentially all) of your exemption, thereby subjecting any further giveaways to estate tax. This could cost you tends of millions of dollars down the road.
One final note: You can use a SLANT even if you’re not married and/or you don’t have kids yet; you simply name your future family as the beneficiaries.
Say you eventually want to give money to your children (or even your grandchildren) and don’t care about retaining practical access to the proceeds when you sell your shares. In that case, an irrevocable trust (sometimes styled as a dynasty trust) could be the right fit. An irrevocable trust with your kids as the sole initial beneficiaries has most of the same benefits as a SLANT — an additional QSBS exemption, moving the assets out of your estate today, control over when and how the beneficiaries access the funds — but also allows you to guarantee that the money will be there and accessible to those beneficiaries down the road.
It’s worth noting here that an irrevocable or dynasty trust can sometimes be a replacement for a SLANT — say, if you aren’t worried about providing for yourself and your spouse, and you’re concerned about what might happen if you get divorced. But this can also be an additional strategy to pursue; you could set up a SLANT for your spouse and kids, and also an irrevocable trust for each child, accessing many more QSBS exemptions along the way.
So far, we have been focused on approaches to QSBS stacking that require you to act early and to give your shares away (to some degree). But what if you don’t want to (or just didn’t) get this done when your company was still new, or you aren’t ready to give so much money away? Enter the Charitable Remainder Trust, or CRUT.
As you may know from our other writing, a CRUT is a tax-exempt entity a lot like an IRA or 401(k). If you place your shares into a CRUT and then sell them, the trust (and you) will owe no taxes when you sell. Those are the highlights, and they apply to any capital gains. But CRUTs can be especially powerful as a tool for QSBS stacking.
How it works: As with a regular CRUT, you place your shares into the trust before you sell. When you do sell, the CRUT pays no taxes, like always. But because the trust gets its own QSBS exemption, then unlike with a normal CRUT, the proceeds will also be tax free when you withdraw them. A QSBS-stacking CRUT therefore allows you to capture an additional $10 million entirely free of tax, and to keep those proceeds for yourself. Plus, you can do this whenever you want — in fact, it typically makes sense to take this step right before you sell, so it’s a measure you can take even after putting off advance planning.
If CRUTs work so well for QSBS stacking, why isn’t this the number one approach? Three reasons.
In summary, QSBS stacking is a powerful strategy for founders and other early equity holder to avoid paying federal and most state capital gains taxes on the sale of their shares. There are various methods of stacking QSBS benefits, each with its own advantages and drawbacks. Founders should carefully consider their individual circumstances and the potential tax implications before deciding on a QSBS stacking strategy. And Valur is here to help. If you are interested in learning more, schedule a call with our expert team today.
We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cos of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.