This Tax Break Can Save Ultra-Wealthy Clients Millions

For almost anyone, $10 million is a lot of money. Now, think about earning that much without having to pay federal taxes.

Sound like a pipe dream? It’s not. Countless founders and early-stage employees at fast-growing companies around the country have done it, taking advantage of a little-known section of the tax code — the qualified small-business stock (QSBS) capital gain exclusion.

First enacted as part of a 1993 budget bill and made permanent in 2015, the exclusion applies to any business, though it’s especially relevant to high-net-worth investors associated with tech startups.

And while it has undergone several evolutions, the upshot is it allows anyone to avoid federal capital gains taxes on the first $10 million in gains derived from qualified company stock.

The problem is that not every advisor fully understands how the exclusion works. Let’s start with the basics because, as with anything, there are a few conditions.

First, the issuing company must be an operating C-Corp with fewer than $50 million in assets. Second, shares acquired from a secondary sale are ineligible. Third, the owner is required to hold the shares for at least five years.

Beyond that, here’s a comprehensive checklist for advisors with clients who own QSBS-eligible stock:

Can a client exercise their stock options early to get the holding period started? 

Yes. Many startups will allow their employees to take advantage of IRS rule 83(b), enabling them to exercise stock options early. Along with getting a jump on the holding period, such a move has the added benefit of potentially minimizing their tax burden even further.

Indeed, because options are taxed based on a company’s valuation at the time of exercise, early movers can realize significant savings if the firm secures more funding at higher valuations.

Under what conditions should you counsel your client to sell their QSBS-eligible stock?

Ideally, anyone eligible would hold their stock until they maximize the full $10 million exclusion. At the same time, advisors must balance that objective against concentration risk and the compounding benefits of diversification.

What should your clients do if they have a lot of QSBS-eligible stock?

Some find themselves with a champagne problem: too much stock and not enough exclusions. Lucky enough, gifted stock retains its QSBS status — so thoughtful trust and estate planning can help them keep more of what they’ve earned.

For instance, let’s say a venture capitalist’s initial $5 million investment in a company is now worth $25 million. They could gift $10 million of it to their child or spouse, who can then claim the exclusion as well, compounding the benefit.

What about tax reform?

The QSBS gain exclusion became more attractive to founders and funders than ever before in 2010, when it was expanded to cover 100% of gains up to $10 million. However, recent tax change proposals seek to limit the benefits of QSBS stock by largely reverting to the pre-2010 rules — in which taxpayers can only exclude 50% of gains.

Such reform is wet cement, but if it sticks around in its current form, advantages still can be maximized by emphasizing slow decumulation and distribution of stock to individuals, rather than trusts. And it is worth noting that even 50% of gains excluded is still a pretty good deal.

What if your client’s company gets acquired before the 5-year holding requirement is up?

If the acquisition was stock-based, the exclusion would likely still apply to the new shares. If it was an all-cash purchase, clients can roll the sale proceeds into another QSBS-eligible investment tax-free, which would keep the holding period timetable intact.

As you can see, taking full advantage of the QSBS exclusion is an ongoing process entailing plenty of nuances. But wrapping your head around these details can set you apart in an environment where high-net-worth investors are increasingly getting paid in company stock.

Andrew Graham, CFA, is founder, managing partner and portfolio manager at Jackson Square Capital, a San Francisco-based wealth management firm.