As noted in this post, the QSBS tax exclusion has increased several times since first implemented in 1993. Therefore, “when” QSBS was acquired impacts the magnitude of the potential tax exclusion. Additionally, “how” the QSBS was acquired impacts whether or not the stock is eligible for QSBS tax exclusion.
The definition of QSBS per Section 1202 (c)(1)(B) includes that “such stock is acquired by the taxpayer at its original issue (directly or through an underwriter).
How can QSBS stock be acquired?
QSBS can only be purchased directly from the qualifying QSBS C Corporation at its original issue. Therefore, stock that would otherwise qualify as QSBS loses this favorable status after it has been purchased through a secondary sale.
QSBS can be acquired through:
- An exchange for any property, not including stock. QSBS that is acquired through the exchange of property is valued at the fair market value of the property on the date of the exchange. (Section 1202 (c)(1)(B)(i)).
- As compensation for services provided to the corporation, except for services performed as an underwriter of the stock. (Section 1202 (‘c)(1)(B)(ii)).
- Upon conversion of other stock if the stock is acquired solely through the conversion of other stock in the corporation. (Section 1202 (f)).
Who can invest in and/or benefit from QSBS tax savings?
Individuals and “pass-through” entities can benefit from QSBS tax savings, but corporations investing in otherwise QSBS eligible entities cannot.
A pass-through or flow-through entity is a legal structure that does not pay income taxes at the business level but passes earnings to its owners to be taxed at the individual’s tax rate. Pass-through entities still file taxes but all tax effects are passed to the owner with a K-1 statement. Unlike C Corporations, pass-through entities do avoid double taxation.
The following types of pass-through entity legal structures are eligible to benefit from QSBS tax savings, as per IRC Section 1202(g)(4):
- S Corporation
- Regulated Investment Companies, and
- Common Trust Funds
Can the QSBS tax exclusion be transferred?
Given the differing tax treatment of various types of gifts, it can become important to understand various differences in ways “gifts” are made when planning, for example:
- If any QSBS is received as a transfer by gift (or at death) the transferee is treated as having acquired the QSBS in the same manner as the transferor and having held the QSBS for the same holding period. (IRC Section 1202(h)(1) and IRC 1202(h)(2)(A)).
- Although Section 1202 does not explicitly address transfers to a grantor trust, tax attorneys note that QSBS could be transferred to a grantor trust. If that transfer is a donative transfer the grantor trust should be treated as having acquired the QSBS in the same manner as the transferor, such that the trust should be able to tack onto the transferor’s prior holding period.
- Regarding “Non-Grantor Trusts”, tax attorneys note that a QSBS holder can set up multiple non-grantor trusts for others (i.e. for their children). The investor can then transfer, by lifetime gift, QSBS to each of those non-grantor trusts. Each of those non-grantor trusts can claim its own $10 million QSBS gain exclusion, separate from any QSBS that the investor decided to retain. Therefore, it may be possible to stack several QSBS exclusions through the use of multiple non-grantor trusts beyond the dollar limits for an individual QSBS exclusion.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.