Maximizing QSBS Benefits with Estate Planning: The Art of Stacking

The number of taxpayers seeking the benefits of Qualified Small Business Stock (“QSBS”) has picked up steam in recent years, particularly since the Tax Cuts and Jobs Act (“TCJA”) lowered the federal corporate tax rates to 21%. The combined effect of lower corporate tax rates together with the benefits of QSBS have made corporations attractive, particularly for startup companies. Section 1202 of the Internal Revenue Code (IRC), which governs QSBS, likewise holds a powerful provision  for those seeking to take care of their estate planning or advise their clients on the same.

The TCJA doubled the estate tax exemption for individuals from $5,490,000 in 2018 to what is now $13,610,000 in 2024 (indexed for inflation). The current estate tax exemption (sometimes referred to as the “Unified Credit”) is currently set to sunset at the end of 2025, so it’s crunch time for those wanting to make gifts now before the exemption will revert to approximately $7M.

Before going any further, a recap of the requirements for stock to be treated as QSBS may be helpful:

1. The company must be a domestic C corporation;
2. The company, during substantially all of the seller’s holding period for the stock, must meet the active business requirement;
3. The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued;
4. The stock must have been received at original issuance; and
5. The stock must have been held for more than five years prior to the sale.

The “original issuance” requirement mandates the taxpayer to acquire the stock on original issuance (which, for QSBS purposes, cannot have been issued prior to Aug. 10, 1993) directly from the company, rather than another shareholder. One exception to the original issuance requirement, however, is that a taxpayer may receive the stock through a gift or as inheritance from another individual who acquired the stock at original issuance.

IRC 1202(h) states that, in the event of a transfer by gift, the transferee (i.e. the recipient of the gift) shall be treated as having acquired the stock in the same manner and having the same holding period as the transferor. The recipient of the gift can either be an individual or a trust. This provision can be used to maximize one’s QSBS exemption by providing each recipient to claim their own $10M capital gain exemption. This strategy has typically been referred to as “stacking.”

Stacking QSBS exclusions may be accomplished by gifting QSBS to one or more family members either directly or indirectly via irrevocable trusts treated as nongrantor trusts (i.e. a trust for which the Settlor of the trust is not the taxpayer and, therefore, the trust must apply for its own EIN), each of which is eligible for a QSBS exclusion from gain on a sale of the stock. This technique is most efficient when the value of the stock is low (i.e., close to the initial formation of the business), such that gifts of the stock use relatively little of the donor’s Unified Credit against estate and gift tax.

An example may help to illustrate the aforementioned “stacking’ technique:

John is the original and sole founder of his tech company, formed as a C corporation in 2018 with his own personal capital of $100,000 in return for 1M shares. In 2023, after 5 years of operation, the company has significant revenue and John receives an offer to purchase his company for $20M. If John would sell his company while holding all 1M shares, he would be entitled to exclude the greater of $10M or 10x his adjusted basis from his adjusted gross income under IRC 1202(b). Assuming John’s only basis in the company is the initial $100,000 which would only yield an exclusion of $1M, John would take advantage of the maximum gain exclusion of $10M (i.e., the greater of the two options over the 10x basis). However, if John were to make a completed gift of half his stock to his child (through an irrevocable nongrantor trust) prior to the sale of the QSBS, John AND the irrevocable trust for his child could each claim the $10M exemption as QSBS excluding $20M of gain vs only $10M, thereby doubling or “stacking” the gain exclusion.

There remains some uncertainty, however, around how many trusts are considered too many. The adage still rings true, which is “pigs get fat, hogs get slaughtered”.  IRC 643(f) provides that two or more trusts are treated as one trust if (1) they have substantially the same grantor and primary beneficiary, and (2) a principal purpose of such trusts is the avoidance of tax. The IRS issued proposed regulations in 2018 including an anti-avoidance provision “to prevent taxpayers from establishing multiple non-grantor trusts or contributing additional capital to multiple existing non-grantor trusts in order to avoid Federal income tax, including abuse of section 199A [of the IRC].”

The proposed regulations presumed a principal purpose of avoidance if the trusts resulted in a significant income tax benefit that could not have been achieved without the creation of the separate trusts (such as the income tax benefit created by stacking trusts holding QSBS). The presumption of tax avoidance did not make it into the final regulations, however, leaving practitioners with little guidance as to what the IRS considers to be abusive regarding the number of separate trusts created to multiply QSBS exclusions.

Because of the lack of guidance, the most conservative approach when setting up multiple nongrantor trusts is to ensure that none of the trust beneficiaries overlap (i.e., creating and settling a trust solely for each individual child or family member). It may also be advisable to document any non-tax purposes for forming each trust and any steps taken to treat it as separate and independent from any other. It may also be advisable to differentiate the trusts by including the appointment of different trustees, varying the timing of distributions and perhaps the distributions standards for each trust.

There are approximately 18 months left before the increased estate tax exemption sunsets, which means now is the time to consider making completed gifts of QSBS. The combined income-tax benefits, coupled with a reduced taxable estate, is the one-two punch clients should seriously consider taking full advantage of when they consult with their estate and tax advisors.