Most people believe that increasing your wealth and lowering your taxes at the same time is impossible. The general population thinks of taxes as barrier to saving more money but that is small minded. A quote by Robert Kiyosaki “Often, the more money you make the more money you spend; that’s why more money doesn’t make you rich – assets make you rich.” Individuals believe that once they get a 9 to 5 job their income earning level is halted, but those who continue to learn and find/create new income levels are those who become rich. Robert Kiyosaki and Tom Wheelwright address many of these challenges and ways to create wealth tax-free in his book Tax-Free Wealth. We will delve into a less than popular way to create tax-free wealth in this article but building new channels of income is outside the purview.
One strategy not addressed in Tax-Free Wealth is the opportunity to invest in small businesses and pay no taxes on the capital gains from selling the stock. This opportunity is found in Section 1202 of the tax code and addresses the guidelines and tax exclusion amount for taxpayers who own qualified small business stock (QSBS). When QSBS is sold it allows for up to a 100% tax exclusion up to $10M or 10x the basis in the stock (i.e. investment or value when received). Section 1202 was written to incentivize investors to allocate capital towards innovation and economic development as well as provide a tax break to workers receiving stock options with the small businesses (e.g. tech-based startups).
The QSBS exemption is not meant to reward rich people but reward those who are helping build the future of our society by taking a risk with their wealth on innovation. An example would be the well-known company Uber. Uber was founded in 2009 with a $200k investment by two angel investors. Uber was targeting an industry with low innovation but pain points that no one realized. Those two angel investors took a chance and are now probably billionaires. For example, let’s assume an investor invested $5M in Uber in 2012 and sold that investment in 2018 for $100M. That investor would be able to exclude $50M* of the capital gains from their taxes!!!!
That exclusion would equate to $11.9M** in tax savings not including state income tax, 44 follow Section 1202, or AMT tax savings. The moral of this example is that sometimes it seems like rich people are finding ways to maneuver out of taxes but that is simply not true. The investor who invest $5M in Uber could have lost all $5M but instead received tax-free gains and helped create over 22k jobs, bringing in billions in sales and payroll taxes. There are a few guidelines below for what constitutes a small business as well as how the stock was acquired:
- Qualified entity structure
- Qualified industry
- Qualified size
- Active trade or business
- QSBS acquisition criteria
- QSBS timeline
- QSBS gain exclusion cap
- Percent of gain excludable
* $5M x 10
** $50M x 20% capital gains tax rate x 3.8% NIIT tax
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.
