Investors Shouldn’t Miss This Often-Unseen Tax Code Opportunity

An often-missed opportunity in the tax code allows a tax exclusion on the gain of up to $500 million from the sale of stock in a qualified small business. And if the Senate’s version of the One Big Beautiful Bill Act passes as-is, investors will have even more opportunities to benefit.

The Section 1202 exclusion is equal to the greater of $10 million or 10 times the shareholder’s basis in the qualified small business stock (QSBS) sold. A shareholder must be a taxpayer other than a corporation.

That means that if five investors each contribute $10 million to a qualified small business in exchange for QSBS, they can each exclude 10 times their invested amount—that is, $100 million of capital gain upon the sale of such QSBS, or $500 million.

However, if an investor contributes $1 million or less to a qualified small business in exchange for QSBS, the capital gain exclusion is limited to $10 million. Again, excluded gain is limited to the greater of $10 million or 10 times the basis.

QSBS Requirements

An investor can benefit from QSBS investments in multiple companies because this opportunity is available on a per-corporation basis. For stock of a corporation to be treated as QSBS, several requirements must be met.

Stock of a domestic C corporation (except for, for example, real estate investment trusts and regulated investment companies) must be issued originally to the shareholder. Stock also must be held for more than five years, and the shareholder’s basis in such stock can’t include any additions to basis after the date on which the stock was originally issued.

That means the stock must be issued from the corporation to the shareholder and can’t be bought from another investor. The corporation’s aggregate gross assets can’t exceed $50 million immediately after the issuance of the stock seeking to be treated as QSBS.

Furthermore, to be treated as a qualified small business, generally at least 80% (by value) of the assets of such a corporation must be used in the active conduct of one or more “qualified trades or businesses.”

This last requirement is intended to ensure that a qualified small business is fully and actively participating in a qualified trade or business and not sitting on cash that isn’t intended for research and development or other start-up costs.

Rights to computer software that produce active royalties can be treated as assets used in the active conduct of a trade or business. Stock and debt in any subsidiary corporation (including foreign subsidiaries) aren’t counted as “assets” for the above requirements.

Instead, the parent corporation is deemed to own its ratable share of the subsidiary’s assets and to conduct its ratable share of the subsidiary’s business. This allows the QSBS exemption to apply to an entire corporate structure, including the sale of a holding company that in turn owns an interest (or interests) in a lower tier subsidiary (or subsidiaries) engaged in qualified active businesses.

Estate Planning

The $10 million exclusion noted above is per married couple. If a married couple ifiles separate tax returns, it reduces the exclusion limitation to $5 million per spouse.

If stock is transferred by gift, the recipient is treated as having acquired such stock in the same manner as the transferor and is deemed to have held such stock as long as the transferor. This means it’s possible to secure multiple $10 million capital gain exclusions by making intrafamily gifts to different taxpayers—a practice referred to as “stacking.”

Let’s say the same investor takes an original $1 million investment and splits it among their four children (or separate non-grantor trusts for each such child) by giving each child (or trust) $200,000 of the QSBS, and retaining the remaining $200,000. The total capital gain that could be excluded is $50 million ($10 million for each taxpayer).

An investor can wait until the QSBS is on the verge of being sold to engage in gifting strategies to allow for multiple $10 million capital gain exclusions. However, initiating such planning at an earlier stage of the company’s development will be more beneficial.

Making intrafamily gifts or gifts to non-grantor trusts will permit stacking of multiple $10 million capital gain exclusions. But it also serves to remove the gifted QSBS from the investor’s estate for estate tax purposes, presumably at a much lower value than when it’s ultimately sold. We encourage investors to consider gifting QSBS as early as they can.

Senate Proposal

The Senate’s most recent version of the One Big Beautiful Bill Act would, if enacted, increase many of the benefits discussed above and make investments in qualified small businesses even more attractive for investors.

The measure introduces a tiered approach permitting exclusion of a portion of gain for stock held for less than five years, allowing a 50% exclusion of gain for stock held for three years and a 75% exclusion of gain for stock held for four years (with the 100% exclusion still applying after five years of holding).

It also would raise the $10 million exclusion amount to $15 million and increase the limit on a corporation’s gross asset valuation to $75 million, both of which would be indexed for inflation.

The Senate’s proposed updates to the QSBS exclusion would make an exceptional opportunity even more remarkable. Even if the Senate’s current version of the One Big Beautiful Bill Act doesn’t become law, the QSBS exclusion in its present state is still an incredible opportunity that investors should seriously consider.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Lewis Greenwald is a tax attorney at Sullivan and Worcester representing multinational corporations, entrepreneurs, and high-net-worth individuals.

Douglas Schneidman is a partner at Sullivan and Worcester representing clients in estate planning and trust and estate administration matters.

Eric Rietveld is an associate at Sullivan and Worcester handles tax planning and compliance matters and tax disputes before government authorities.

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