What if You Have More than $10MM in QSBS Gains?

Since the QSBS capital gain exclusion is limited to $10,000,000 per issuer (or 10x the basis, if greater), those with excess gains often seek guidance in extending their favorable tax treatment. 

The good news is that there are a number of possibilities at your disposal. Since each taxpayer has their own $10MM limit, you may be able to extend QSBS treatment through various gifting strategies.

Having said that, there are numerous financial planning implications to each of these approaches. For example, gifts to non-charitable entities will generally reduce the amount of your estate tax exclusion. Each of these strategies will also impact your income taxes. Therefore, an integrated approach is in order.

Case Study

To demonstrate some of these strategies in action, this article will consider the case study of Jane and Bill, with the relevant facts below:

Under the QSBS rules, they qualify for a capital gain exclusion of $10,000,000. However, the remaining $8,000,000 would be subject to a combined tax rate of 33.8% (23.8% federal and 10% state). 

The idea of paying over $2,700,000 in combined taxes on the excess QSBS shares is not appealing. Below are some options to avoid this tax:

Gift the excess shares to their children

QSBS shares can be gifted without sacrificing their tax treatment. The recipient treats the shares as if she acquired them on the same date and in the same manner as you, and can use her own $10MM exclusion.

Therefore, one option is to gift $4,000,000 outright to each child, who could sell the shares immediately with no federal income taxes. 

An advantage to this approach is that the shares, along with all future growth, will no longer be part of Jane and Bill’s estate.

However, here are some of the downsides to this approach:

• They will give up a large portion of their wealth.

• Their estate tax exclusion will be reduced by the size of the gift.

• They worry about their kids losing this money in a lawsuit or divorce.

• A gift of this magnitude will impact their children’s lives in several ways, some of which could be negative.

Gift excess shares to an irrevocable trust

Many parents are uncomfortable making an outright gift of this size. They might want their children to feel like they made it on their own, for example. It might negatively impact their kids’ work ethic or create marital tension. They might worry about their children making poor financial decisions with the funds.

To alleviate these concerns, Bill and Jane could consider gifting the excess shares to an irrevocable trust. In general, trusts with their own taxpayer identification number (TIN) are afforded their own $10MM QSBS limit, preserving the favorable tax treatment on the $8MM excess.

Similar to the above, the transfer would be considered a gift, reducing Jane and Bill’s estate tax exclusion. 

The trust could limit the conditions under which their kids or future grandkids could receive distributions. Common examples include education, home purchases, starting a business, etc. They could also specify a distribution schedule over a set number of years to allow their children to gradually adjust to their new economic reality.

Here are some of the downsides to this approach:

• The trust must be irrevocable, meaning they will lose control as soon as the trust is funded.

• Their estate tax exclusion will be reduced by the size of the gift to the trust.

• The trust’s annual investment income will be subject to trust tax rates, which are usually higher than personal tax rates.

Gift excess shares to charity

If Jane and Bill are philanthropic, they could donate the $8MM excess shares to one or more charities. In addition to supporting causes they care about, they could claim a deduction for the full market value of the shares ($8MM) and fully avoid capital gains taxes. 

However, deductions for donations of appreciated assets are limited to 30% of adjusted gross income (AGI). Although the excess amount could be carried forward for up to five years, the 30% of AGI limit continues to apply each year.

Here are some of the downsides to this approach:

• They would lose access to the $8MM.

• Their income may not be high enough to use the entire deduction, even with the five-year carryforward.

• A gift of this size might overwhelm smaller charities.

Gift excess shares to a Donor-Advised Fund

A Donor-Advised Fund (DAF) is an investment vehicle that allows distributions to qualified charities to be made over time. With minor exceptions, contributions to a DAF generally receive similar tax treatment as outright donations. 

DAFs allow donors to take their time finding the right charitable giving opportunities, and solve the issue of small charities receiving more than they can manage. Assets in the DAF are invested and can potentially grow until distributed.

DAFs are also a wonderful tool to promote family continuity. Donors can name their children (or other family members) as co-advisors, actively including them in the decision-making process. Families will often convene meetings 1-2 times per year to make distribution decisions, giving each member a chance to prepare and present recommendations. This process creates a powerful source of purpose and establishes strong family values.   

DAFs also permit successor advisors to be named, allowing them to continue functioning after the death of the donors. This allows the donors’ descendants to carry on the harmonious gift-giving process long after they’re gone. 

Up until recently, families would establish a private foundation to accomplish these functions. However, DAFs generally offer a more advantageous and modern solution. They offer complete donor privacy, are exempt from annual distribution requirements, and require no attorneys or accountants to establish and administer.

Here are the downsides to this approach:

• They would lose access to the $8MM.

• Their income may not be high enough to use the entire deduction, even with the five-year carryforward.

Gift excess shares to a Charitable Remainder Trust (CRT)

A CRT is an elegant solution that maintains some of the benefits of charitable giving while still providing significant financial benefits to the donor.

A charitable remainder trust works as follows:

• Funds are contributed to the trust, such as cash or appreciated assets.

• The trust pays income annually over a set number of years or the lifetime of the donor(s). The payout rate must be at least 5% annually. 

• At the end of the term, all remaining assets are distributed to the charities named in the trust.

Donors claim a charitable deduction for the present value of the amount expected to go to charity, which varies according to the terms of the trust. In general, the lower the payout, the greater the deduction. If the trust is funded with appreciated assets, the deduction is limited to 30% of AGI, with a five-year carryforward for any unused deduction.

Donors have numerous options in setting the terms of the income payout. The trust can pay out a fixed percentage of trust assets (known as a Charitable Remainder Unitrust, or CRUT). If trust investment growth exceeds the payout rate, distributions can grow over time. The trust can also pay a fixed amount each year (known as a Charitable Remainder Annuity Trust, or CRAT). With a CRAT, distributions can be deferred for a set number of years, increase the up-front deduction.

If Jane and Bill donate $8MM of shares to a CRUT with a 5% annual payout, they would receive income of $400,000 in year one, with subsequent distributions determined by the performance of the trust. Based upon today’s interest rates, they would receive a charitable deduction of roughly $2.6MM, subject to the 30% of AGI limit and five-year carryforward.

Here are the downsides to consider:

• They would have to hire an attorney to set up the trust.

• They would have to engage a third party to handle all trust administration, including tax returns, reporting, etc. 

Outcome

The best financial planning outcomes usually combine the best of several approaches. With that, Jane and Bill chose a multi-pronged approach that best met their needs. They chose to:

• Gift $1,000,000 directly to their children ($500k to each), each of whom sold the shares tax-free. This one-time gift helped jump start their lives without creating a sense of dependence or entitlement.

• Direct $500,000 into a Donor-Advised Fund, thereby prepaying much of their planned charitable contributions over their lifetime.

• Contribute $1,500,000 into a Charitable Remainder Trust that will pay 5% annually over their joint lifetime.

• Sell $2,000,000 of shares outright, using the deduction produced by the CRT and DAF to reduce the impact of the taxable gain

They chose to hold onto the remaining $3,000,000 for now, which they will deploy later in life as their situation evolves.

In considering your own situation, much will depend upon your unique goals and needs. Perhaps most importantly, be sure to work with qualified experts who can effectively integrate the various pieces of your financial life.

Either way, be sure to work with a team of competent advisors to ensure you are receiving accurate and current advice.

Nothing in this article shall be construed as tax or legal advice. The content is provided for informational purposes only and, there can be no guarantee of its accuracy. Consult your personal advisors prior to acting on any of the information contained in this article.

About the Author

Michael Yoder, CFP® is principal at Yoder Wealth Management (www.YoderWM.com), which provides high-end financial planning and investment advice for individuals and families. You can find more information here.

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