This is Part 2 in a series I have written on the use of QSBS in estate planning. Part 1 focused on what is qualified small business stock.
QSBS & Non-Grantor Trusts
If a business has qualified small business stock under IRS Section 1202, the benefits of QSBS can be expanded on with the effective use of non-grantor trusts.
What is a Non-Grantor Trust?
Trusts are taxed in two different ways.
A grantor trust refers to a pass-through trust, in which any income attributed to the trust is taxed directly back to the individual who created the trust (the grantor). In a grantor trust, it does not matter if the income stays in the trust or was distributed out to the beneficiaries of the trust.
By contrast, a non-grantor trust is a trust in which the trust itself is its own taxpayer. Any income generated from within a non-grantor trust will be taxed directly to the trust (at compressed trust tax rates), unless the income is distributed out to the beneficiaries of the trust, in which case the income will be taxed at the beneficiary’s own tax rate. If the trust income was not distributed to the beneficiaries, then the trust tax rate is compressed. For example, if a non-grantor trust earned more than $12,950 in income, the trust would owe $3,129 in taxes, plus 37% on any income above $12,950.
A Common QSBS Example
Let’s imagine that Robert and Sarah own a California startup worth $20 million. If the startup otherwise qualifies for QSBS and had a QSBS basis of zero, then the first $10 million of sale proceeds would be exempt from federal capital gains tax. However, $10 million still would be subject to capital gains. (It is important to note that at the time of this writing, Congress has allowed for 100% exemption of the Section 1202 Gain Exclusion, though this number can be reduced in future legislation).
The $10 million exclusion from capital gains is “automatic” in the sense that, as long as the shares qualify under IRC Section 1202 as QSBS, there is nothing that Robert and Sarah need to do further to get benefit under 1202.
However, there are still two problems that should be addressed. First, do Robert and Sarah want $20 million to be held in their own names after the sale? If so, this $20 million will continue to grow during their lives and, at their death, the $20 million will be worth far greater. All of this will be subject to estate taxes when they die.
Secondly, Robert and Sarah will still need to pay taxes on the $10 million of gain that was not excluded under 1202. This can be sizeable especially for California residents. In other words, over $3.7 million will be lost in taxes (at a 37.1% combined state and federal capital gains tax rate).
Can Robert and Sarah do better?
The answer, fortunately, is “Absolutely!”
Trusts to the Rescue!
First, by gifting into and then selling the shares of the C-corp from an irrevocable non-grantor trust, the trust becomes eligible for another $10 million deduction under Section 1202. Therefore, not only do Robert and Sarah get a $10 million deduction using their names as sellers, but the trust also gets another $10 million deduction since it is a separate taxpaying entity. Therefore, if administered the right way, the entire $20 million should escape federal capital gains tax.
Secondly, if the non-grantor trust was structured as a completed gift, NING trust, the entire $20 million could also escape California income taxes as well!
Finally, Robert and Sarah would be advised that even though they could sell the first $10 million of shares in their own names and still get 1202 treatment, they would be advised not to do so, because of the simple fact that the proceeds from the sale will still be part of their taxable estate at death. Instead, Robert and Sarah would be better off gifting $10 million of shares into a grantor trust since the proceeds from the sale would be protected and placed into the trust and could then grow estate-tax free during their lifetime and possibly even for the lifetime of future generations! The grantor trust would still receive the original tax break under QSBS, since the trust would use Robert and Sarah’s social security numbers to qualify for 1202 treatment.
With the use of a non-grantor and grantor trust, not only could Robert and Sarah avoid federal capital gains taxes, they may also escape California income taxes, as well as keep all $20 million free and clear of federal estate taxes forever.
Thus, the judicious use of trusts certainly does ensure that Robert and Sarah can do much better.
In fact, the tax benefits using trusts can be so powerful that many businesses that are not taxed as C corporations choose to reorganize their companies in such a manner that will later qualify them for this benefit. Such planning must be done very carefully since any small misstep may disqualify a business forever from 1202 treatment. Our firm specializes in this type of counsel and restructuring. Note that a simple conversion from an S corporation to a C corporation not only will not qualify a business for 1202 treatment but may also cause adverse tax consequences in the process. Thus, it’s important to work with qualified advisors before embarking on such a move.
As noted, this type of planning can be exceptionally complicated because of latent issues that hide underneath the surface, which only an experienced attorney will know to look for. For example:
- Do the shares of the business constitute community property assets? If so, it is important not to cause estate tax inclusion if the spouse is listed as a trust beneficiary. A distribution approval process involving adverse parties may need to be implemented into the body of the trust to permit distributions to spouse beneficiaries.
- Can the shares be transferred into the trust in a manner that still preserves the QSBS nature of the shares? For example, selling QSBS shares to a trust almost always disqualifies the shares from eligibility.
- Will the transfer to trust trigger any gift taxes? What kind of valuation discounts, if any, should be used?
- Do the shares need to be recapitalized?
It is highly advisable to use this technique well before any liquidation events are even on the horizon. For one thing, it is always cheaper to transfer shares in a closely-held business well before an exit, while they are still inexpensive. Secondly, business owners will want to avoid any argument that the transfer was done in contravention of the assignment of income doctrine.
We have advised countless businesses in order to help qualify them for QSBS and have built estate planning techniques around non-grantor trusts in order to maximize the potential tax savings. Please reach out to us if you have any questions on implementing this technique.