Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use QSBS to Eliminate Capital Gains Tax
Transcript
- Lucas: If you're an entrepreneur who's built a company worth, say, fifty million dollars, and you're looking at selling, the federal capital gains tax alone on your profit could be twenty percent. But there's a provision in the tax code that can wipe out that entire bill. It's called Qualified Small Business Stock, QSBS, and it's under Section 1202 of the Internal Revenue Code. Luna: And this isn't some obscure loophole for the super wealthy. It's been around since 1993, but most people just don't know about it. Lucas: Exactly. The basic idea is that if you acquire stock directly from a C corporation with total assets under fifty million dollars, and you hold that stock for at least five years, you can exclude a portion of the gain from federal tax. The exclusion is the greater of ten million dollars or ten times your basis in the stock. Luna: So for a founder who put in one million dollars and sees the company grow to fifty million, they can sell and pay zero tax on the first ten million of gain. That's an enormous saving. Lucas: Right. And the provision applies per issuer. So if you've got multiple companies that qualify, you can multiply the benefit. But there are a lot of rules that trip people up. For example, the company must be a C corporation at the time the stock is issued. Most startups are LLCs or S corporations. Luna: But can you convert to a C corp and still qualify? Lucas: You can, but the clock starts from the date of conversion. So if you've already been operating as an LLC for three years, you need to wait another five after converting to a C corp. That's a long holding period. Some families plan for this by starting as a C corp from day one. Luna: What about gifting shares to family members? Can they also get the exclusion? Lucas: Yes, and this is where the strategy gets powerful for wealth transfer. When you gift QSBS to a family member, they inherit your holding period. So if you've held the stock for five years, the recipient can sell immediately and claim the exclusion on their own return. But there's an attribution rule—you have to be careful not to exceed the per-issuer limit across family members. Luna: So a founder could gift shares to their spouse, children, and maybe even a trust, and each could get their own ten million dollar exclusion? Lucas: Within limits. The exclusion applies per taxpayer, so yes, each individual can exclude up to ten million per issuer. But the attribution rules under Section 318 can aggregate ownership, so it's critical to work with a tax advisor to structure it properly. A common technique is to use a GRAT, a grantor retained annuity trust, to pass stock to beneficiaries without triggering gain. Luna: And what about the fifty million dollar asset test? Does that include cash? Lucas: It includes all assets, but the test is done at the time of issuance and whenever the company issues new stock. So a company that later goes above fifty million doesn't disqualify shares issued earlier—it just means new shares won't qualify. That's why early investors and founders get the benefit. Luna: Let's walk through a real scenario. Say a founder puts in two million dollars, builds the company to a hundred million, and sells after six years. Lucas: Good example. Their gain is ninety-eight million. The exclusion is ten million—since ten times two million is twenty million, but the cap is ten million per issuer. So they pay tax on eighty-eight million. Still, saving ten million in tax is substantial. And if they had gifted some shares earlier, the family could exclude more. Luna: I've heard that some families use QSBS in combination with opportunity zone funds. Is that possible? Lucas: It is. You can sell QSBS stock and reinvest the gain into a qualified opportunity fund, deferring the tax until 2026, and potentially get a step-up in basis. But you have to be careful not to exceed the exclusion. The opportunity zone rules are separate and have their own deadlines. Luna: So this isn't just for tech founders. It applies to any qualified trade or business—manufacturing, service companies, even certain real estate if it's an active business. Lucas: Right. But not for personal service businesses like law or medicine, hospitality, or farming. The code excludes those. So it's really for operating companies that produce goods or provide non-personal services. Luna: One thing that surprises me is that QSBS can be used with ESOPs. I've seen cases where a founder sells to an employee stock ownership plan and uses the proceeds to buy QSBS in another company. Lucas: That's a sophisticated strategy. Under Section 1042, you can defer gain from selling to an ESOP by reinvesting in QSBS. It's a way to recycle gains tax-free into new ventures. And if you hold that new QSBS for five years, the gain on that becomes eligible for exclusion too. Luna: It's amazing how many layers there are. But for most listeners, the key takeaway is: if you own shares in a small C corporation and have held them for at least five years, you might be sitting on a huge tax asset. Lucas: Exactly. And even if you didn't plan for it, you can sometimes restructure. For example, you can convert an S corp to a C corp and then wait five years. But the planning needs to start early. Luna: I've also heard of families using QSBS to fund charitable trusts. They donate the stock to a charitable remainder trust, the trust sells it tax-free, and then the family gets an income stream. Lucas: That's right. The trust can sell the QSBS without triggering tax, reinvest the proceeds, and pay the donor income for life. Then the remainder goes to charity. It's a way to combine philanthropy with tax efficiency. Luna: Before we wrap, if today's conversation helped you think about your own stock or business differently, I'd mention that listener support is what keeps this show ad-free and independent. Lucas: Yeah, if this was worth a coffee to you, that link — buy me a coffee dot com slash fexingo — is an easy way to show that. No pressure, just if the show adds value to your week. Luna: Totally. So back to QSBS — another angle is that the exclusion can be stacked with the net investment income tax. Because the excluded gain isn't considered net investment income, you avoid that extra 3.8 percent as well. Lucas: Good point. So in high-tax states, the total saving can be over thirty percent. For example, in California, the state tax would be over thirteen percent, but QSBS only applies for federal purposes. States like California don't conform to Section 1202, so you still pay state tax. Luna: That's a crucial nuance. So if you're in a high-tax state, you need to plan for that. Some families relocate to states that do conform, like Texas or Florida. Lucas: Right. And there's a potential for a federal legislative change. Every few years, there's talk of capping or repealing Section 1202. But so far, it's survived. Given the current fiscal environment, it's worth watching. Luna: For now, it's still one of the most powerful tools for reducing taxes on business growth. If you're an entrepreneur or advise one, you owe it to yourself to understand QSBS. Lucas: Absolutely. And we'll put a link to more resources in the show notes. Thanks for listening — and if you want to support the show, you know where to find us. Luna: Yeah, thanks for being here. We'll talk next time. Lucas: Take care. Luna: Bye.