NONGRANTOR TRUST FOR QSBS EXCLUSION PURPOSES
Section 1202 of the Internal Revenue Code (IRC) was enacted to encourage investment in specific types of small businesses by providing an exclusion of certain gain from the sale or exchange of qualified small business stock (QSBS). The primary benefit for holders of QSBS is a potential exclusion of 100% of eligible gain on a sale or exchange of QSBS issued after September 27, 2010 and held by a taxpayer for at least five years. This tax benefit is a major advantage for many of our clients who are founders or investors. Most jurisdictions, including New York State and New York City, conform to federal income tax treatment of QSBS, effectively allowing an equivalent exclusion for state and local income tax purposes. (Note that states such as California and Pennsylvania do not follow this federal treatment.)
Generally speaking, the amount of eligible gain that may be excluded with respect to a single qualified business will be capped at $10 million, collectively for all tax years. Regardless, many founders and investors hold QSBS that would generate taxable gain in excess of that eligible amount, especially upon an exit. For QSBS holders who are looking to take advantage of estate planning opportunities, IRC section 1202 provides a tremendous benefit by extending QSBS benefits to donees who acquire their QSBS by gift.
A donor who makes a gift of QSBS should be permitted to exclude QSBS gain up to the eligible amount. Founders and investors with large positions in QSBS may wish to consider gifting to a nongrantor trust to multiply the number of QSBS exclusions available to offset taxable gain. It should be noted that under the Treasury Regulations, two or more trusts will be treated as one if they have “substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries” and if a primary purpose for the transfers was the avoidance of federal income tax. Planning must be carefully crafted around this consideration, along with others that go beyond IRC section 1202. Such considerations include liquidity for the founder/investor making the gift; gift, estate and income tax liability; asset protection; and maintenance of ownership and control by the grantor. In addition, because the strategy of gifting to a nongrantor trust requires taxable gifts that use all or a portion of a grantor’s lifetime federal gift and estate tax exemption, undertaking estate planning at an early stage is often critical to maximizing the potential benefits of IRC section 1202.
If you are a founder or investor in QSBS, please contact us to discuss the tax benefits of gifting to a nongrantor trust to maximize the benefits of QSBS exclusion while achieving valuable estate planning objectives.