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Younger individuals (who may not yet be married or have children) are quite likely understandably less interested in the use of trusts for traditional estate tax planning purposes than older individuals with families. That is so even if those younger individuals have estates well over the estate tax-exemption amount. The potential to save income taxes through trusts, however, should be of great interest to such individuals.
The use of trusts to “multiply” or “stack” the exclusion from capital gain on the sale of “qualified small business stock” is but one available income tax savings opportunity through the use of trusts. Section 1202 of the Internal Revenue Code provides for an exclusion of up to $10,000,000 of capital gains (or, if greater, an exclusion of up to 10 times one’s basis) in connection with the sale of qualified small business stock (QSBS), as such term is defined under Section 1202(d). While notionally this exclusion is quite substantial, founders or early investors in many companies may have significantly greater gain in their shares (and/or they may anticipate significant future gain in such shares) than might otherwise be covered by this exclusion.
In general, to be QSBS, a stock must be in a C corporation with less than $50,000,000 of aggregate gross assets at the time of acquisition that was acquired by the taxpayer at its original issuance, either in exchange for money or other property (not including stock), or as compensation for services provided to the corporation. Importantly for planning purposes, however, section 1202(h) provides for an exception to the general rule if the stock is acquired by gift, stating that “…the transferee shall be treated as having acquired such stock in the same manner as the transferor.” A further requirement to qualify under section 1202 is that the stock must have been held by the taxpayer for more than five years as of the time at which it is sold or exchanged. This is also covered by section 1202(h), which further provides that “…the transferee shall be treated as having held such stock during any continuous period immediately preceding the transfer during which it was held (or treated as held…) by the transferor.”
Since the gift tax exemption is currently high (albeit only temporarily so since the law providing for the current $12,060,000 exemption is scheduled to sunset on December 31, 2025), taxpayers holding QSBS have a relatively short window of opportunity to transfer the maximum possible number of shares, by gift, into trust, without the imposition of a gift tax. Those transferred shares will then hopefully appreciate while held in trust, so that the trust can later sell those shares and avoid capital gains tax by reason of section 1202 on its own gain, while the original taxpayer similarly avoids capital gains tax by reason of section 1202 on the shares that he or she did not transfer, thereby effecting a possible doubling of the section 1202 exclusion.
Of course, the trust that ultimately sells the shares must be treated as a trust that is not the alter-ego of the transferring taxpayer (i.e., it cannot be a so-called “grantor” trust). This requires sophisticated trust drafting, especially if the taxpayer wishes to retain the potential for a future direct benefit from the assets held in trust. Curiously, the fact that the wealth held in trust is then also outside of the taxpayer’s taxable estate, as well as protected from the grantor’s potential future creditors, including a possible future former spouse – all objectively important further benefits of the planning – is often regarded by the taxpayer as merely “incidental” benefits of the planning.
In addition to an exclusion from federal income tax, the tax laws of many states provide a similar exclusion for state income tax purposes, further enhancing the potential tax savings inherent in such planning with qualified small business stock in trust.
Theoretically, the multiplication of the tax benefit under section 1202, once the initial transfer of shares into trust is complete, is limited only by the amount of growth that might thereafter be achieved in the price of the shares and the number of trusts the taxpayer might choose to create. As a practical matter, however, the Treasury regulations provide a rule, sometimes referred to as the “multiple trust rule,” which provides that “…two or more trusts will be aggregated and treated as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing one or more of such trusts or for contributing additional cash or other property to such trusts is the avoidance of Federal income tax.” Cautious taxpayers, of course, will account for the possible application of the multiple trust rule in effectuating their planning.
The benefits of trust planning with QSBS are best demonstrated by an example. Imagine that an individual transfers $12,060,000 of QSBS, in which he has zero basis, representing three-quarters of his stock holdings, to a trust. Inasmuch as the value of those shares falls within the taxpayer’s gift tax exemption, there is no gift tax. The value of the shares subsequently increases in value by 2.5x, such that the value of the taxpayer’s individually owned shares is then $10,000,000, and the value of the shares held in trust is then $30,000,000. Imagine then that the trust the taxpayer created splits into three separate non-grantor trusts, each with a different primary beneficiary or beneficiaries in order to avoid the application of the multiple trust rule. In a subsequent liquidity event, all the shares are sold (by the individual, and by each of the three trusts), and no capital gain is imposed at the federal level (and quite possibly at the state level), due to the taxpayer’s thoughtful advance planning towards “multiplying” or “stacking” the section 1202 benefit.
Daniel S. Rubin is a partner with Farrell Fritz, P.C., a New York-based law firm.
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