QSBS Stacking Options

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.

Gifting

Pro: The simplest approach | Con: Give up control and access

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.

• Ownership. First, if you give shares away, you no longer control them. This means that someone else — the person to whom you give the shares — will have voting rights, as well as the right to decide when to sell. This can be a problem for the gifter, and it could also raise red flags for the company: Most companies prefer not to have a bloated cap table for many reasons, and many retain the right — via the standard stock purchase agreement — to veto the transfer of shares to another person.
• Control. Second, if you give shares away, the recipient…receives them. While most pop estate lawyering (if there is such a thing) bears little resemblance to actual best practice, there is one dynamic that gets fair treatment: The near-universal desire to make sure that your kids don’t have access to too much money too soon. QSBS gifting can raise this exact problem; if you simply gift shares to your children, they own them, and they can do what they want with them. This could be a problem if, say, you give 500,000 shares in your brand new startup to your 7-year old and the business takes off. Fast forward 8 years, you’re ringing the bell at the Nasdaq, and you realize that your hormone-addled 15-year old has an 8-figure net worth with no strings attached. Not great.
• Access. The third drawback is potentially more significant, but also subject to more clever workarounds. If you give your shares away for QSBS purposes, you will technically no longer have access to the proceeds. If those shares end up worth 7 or 8 figures, that’s a lot of money to give away, especially to someone outside your immediate family. There may be ways, in practice, to ensure that you can use some of the proceeds — maybe the recipient ends up gifting some of the money back to you, or making a big purchase for you — but such transfers implicate a laundry list of IRS rules that could complicate the situation, so it’s never advisable to count on this kind of hack.

Spousal Lifetime Access Non-Grantor Trust (SLANT)

Pro: Estate tax benefits + QSBS stacking | Con: You need to act relatively early

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?

• Control. With respect to control, although you do give up control over your shares when you place them in a SLANT, just as you would if you gave them away, you get to name the trustee of the trust. If you choose wisely, you can place someone in that role whom you can trust to act prudently — to vote the shares reasonably, to sell them at the right time, and to be smart about when the beneficiaries (most importantly, your kids) get access to the funds.
• Access. In addition, the trust can allow you to retain the benefit of the proceeds in practice. It is true that you will not technically have access to the proceeds in a SLANT, your named beneficiaries will. If you name your spouse as the primary beneficiary, then, barring divorce or other interpersonal complications, you will benefit from the trust’s funds, which your spouse can use for his or her “health, education, maintenance, and support” — including things like your (shared) mortgage, your kids’ college expenses, and the like.
• Reducing estate tax. SLANTs also have one further advantage over simple QSBS gifting. If you just give your shares to your spouse in return for an additional QSBS exemption, the assets will remain part of your estate. Why does that matter? A quick primer on estate tax: You can give away a set amount of money during your lifetime free of estate tax and when you pass away. (This lifetime gift exemption fluctuates with federal law, but today it stands at about $13 million per person, and $26 million for married couples.) Every dollar you give away above that amount is subject to significant estate tax — often upwards of 50% or more. If you give your shares to your spouse without a trust, they stay in your estate, and any appreciation — potentially massive appreciation in the case of a successful startup — will also stay in your estate. When you go to give the proceeds away, to your kids, or to anyone else, you will be subject to that punitive estate tax we mentioned earlier. Better to give the shares away via a qualified trust; if you do it that way, the shares immediately leave your estate, and any appreciation can pass to your spouse, and then to your kids, free of estate tax.

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.

Irrevocable trust

A lot like a SLANT but access is even more limited

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.

Charitable Remainder Trust

A (very) different approach, focused on you

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.

• Timing. First, the timing is tough. Due to the nature of trust accounting, it typically makes sense to set up a QSBS stacking CRUT for only four or five years. This way, you’ll get the proceeds out of the trust quickly, and they’ll be mostly tax free. (If you ran the trust for much longer, you’d capture significant growth even after selling your shares, and all of those gains would be taxable when you withdraw them. And because CRUTs operate on a highest-taxed-distributions-first accounting system, those taxable gains would leave the trust before the QSBS-eligible gains, potentially trapping the tax-free money in the trust forever.) But if your trust is only going to last for a few years, you really need to make sure you’re going to be selling your shares soon before you establish the trust; otherwise, the trust might end before you make the sale, triggering a whole host of tax complications. As a result of these constraints, it makes sense to establish and fund the trust in the days — or even hours — before your share sale goes through. It can be done — we’ve done it for dozens of clients, and it’s still a great solution if you didn’t do the recommended advance planning via gifting or SLANT — but it adds a layer of logistics to your deal that you might want to avoid.
• Estate tax planning. Second, with a QSBS-stacking CRUT, the proceeds remain yours and, as a result, they remain in your estate. This means that when you eventually get around to giving the money away to your kids or others, the gift will be subject to estate tax.
• Charitable giving. Finally, a CRUT is a charitable trust. By rule, you will give about 10% of the proceeds to a charity. A charity you choose, to be fair, and this could be your own donor advised fund or family foundation, but you’re still giving the money away.

Conclusion

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.

Related Readings

• QSBS Stacking: How to Stack Up the Benefits?
• QSBS: Qualified Small Business Stock Explained
• Case Study: QSBS benefits with a Charitable Remainder Trust

About Valur

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.