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IRC Section 1202, governing Qualified Small Business Stock (QSBS), is one of the most powerful tax benefits available to your client and prospect business owners today. When properly structured, this tax provision allows business owners to exclude up to $10 million in capital gains exclusion or 10 times their cost basis when selling their qualified business.
For financial advisors working with business owners, understanding "stacking" and "packing" strategies can turn this tax benefit into a powerful wealth preservation tool.
The History of Qualified Small Business Stock (QSBS) and IRC 1202
The PATH Act of 2015 made this 100% exclusion permanent. Stock acquired between August 11, 1993, and February 17, 2009, qualifies for a 50% exclusion, while stock acquired from February 18, 2009, through September 27, 2010, qualifies for a 75% exclusion. Any qualifying stock acquired after September 27, 2010, benefits from a 100% exclusion.
Who Qualifies?
To qualify, a business must be a C-corporation with assets under $50 million at stock issuance. Eligible industries include technology, manufacturing, wholesale/retail, and construction.
Service-based businesses, including professional services, healthcare, financial services, and businesses where the principal asset is employee expertise, typically do not qualify.
Advanced Strategies to Maximize the IRC 1202 Impact
What if your client or prospect’s business is worth $50 million? In a traditional exit, the owners might face capital gains tax on the entire amount. However, strategic QSBS planning can change the outcome dramatically.
Here is how stacking and packing work together to maximize benefits.
IRC 1202 Stacking: Spreading the Gains Across Multiple Taxpayers
Your client or prospect can multiply the benefit of the $10 million capital gains exclusion through Stacking. The strategy multiplies the exclusion benefits across multiple taxpayers.
Let us look at a hypothetical example with a business owner and family trust
- A business owner and spouse create four irrevocable trusts for their children in tax-friendly states (e.g., Nevada, Wyoming).
- They gift $10 million in QSBS stock to each trust.
- Using IRC 2704, they apply a 30% valuation discount, meaning the total gift value for tax purposes is $7 million per trust (within the lifetime exemption).
So, what’s the result of our hypothetical scenario?
- Now the owner & spouse qualify for $10 million each in capital gains exclusion.
- Each of the four trusts also qualifies for a $10 million capital gains exclusion.
- If the business sells for $50 million, the total tax-free capital gains could reach $50 million.
In addition, the growth on the completed gifts to the trust grows outside of the estate, also saving what could be millions in estate taxes, which are paid at a 40% rate for assets above the lifetime exception.
In this hypothetical example, you could have saved the family state income tax, capital gains tax, and estate taxes. That is not bad for one planning concept.
IRC 1202 Packing: Increasing the QSBS Basis for a Higher Exclusion
While stacking spreads benefits across taxpayers, packing maximizes each exclusion through strategic basis increases. The objective in packing is to increase the 10-times basis multiplier under IRC 1202. Strategic additional investments can dramatically improve the potential exclusion amount.
Qualifying contributions to increase basis include cash, specific business property, and patents or similar intellectual property. Stock received for services does not qualify. The key is that each contribution must meet QSBS requirements when it is made, and the company's total assets must remain under $50 million.
Here is a simple hypothetical example of packing:
- A business owner invests $1 million in QSBS.
- At the same time at initial issuance he contributes, they contribute an additional $4 million in qualifying investments like cash, equipment, and patents which can increase their basis.
- This raises the QSBS basis to $5 million.
- Instead of the standard $10 million exclusion, now the 10x basis rule allows up to $50 million in tax-free capital gains.
However, each packing transaction requires careful documentation and timing to maintain QSBS qualification. This is why we want to stress the importance of working with qualified tax counsel to ensure the proper structuring of these additional investments.
The Power of Combing Stacking and Packing
When properly executed, combining stacking and packing creates a remarkable outcome that you can bring to your clients and prospects.
Their business, which might have faced significant capital gains tax on a $50 million exit, can potentially eliminate those taxes while achieving important estate planning objectives.
As we always stress at Dunham, the key lies in early planning and careful coordination among professional advisors. Remember, you are the quarterback for your client.
Beyond Tax Savings: Business Succession & Legacy Planning
While tax benefits drive these strategies, the advantages go beyond tax savings.
These approaches can facilitate business succession planning, create efficient wealth transfer, and help protect assets for future generations.
The key is understanding how these strategies work together to maximize benefits for your clients.
Closing Thoughts for Financial Advisors
The powerful benefits of IRC 1202 provide exceptional opportunities for business owners. Strategies like stacking and packing magnify these advantages. When properly structured, these can dramatically reduce or eliminate capital gains tax on business sales while achieving important estate planning objectives.
These strategies require years to develop and cannot be used when the business owner has an offer in hand. As such, early discussion with clients and prospects is important, and Dunham and Dunham Trust Company is here to help.
By understanding these strategies, you position yourself to deliver significant value to your business owner clients and prospects.
To learn more about implementing IRC 1202 strategies for your clients, contact our Business Development Team at 858-880-5778 for your complete Financial Advisor Guide to IRC 1202.
Sources:
- 1202: Small Business Stock Capital Gains Exclusion, by Tina M. DeSanty, CPA, April 30, 2023, https://www.thetaxadviser.com/issues/2013/may/clinic-may2013-story-07.html
- Tax Planning Opportunities with QSBS – “Packing” & “Stacking”, by Wealthsprire Advisors, January 1, 2024, https://www.wealthspire.com/guides-whitepapers/tax-planning-opportunities-with-qsbs-packing-stacking/
- Stacking and Packing – Strategies to Maximize the Section 1202 Exclusion, by Daniel Mayo, 8/20/ 2021, https://www.withum.com/resources/stacking-and-packing-strategies-to-maximize-the-section-1202-exclusion/
- Section 1202 – An Overview, by Wealthspire Advisors, January 1, 2024, https://www.wealthspire.com/guides-whitepapers/tax-planning-opportunities-with-qsbs-packing-stacking/
- Maximizing Section 1202’s Gain Exclusion, by Frost Brown Todd Attorneys, January 17, 2024, https://frostbrowntodd.com/maximizing-the-section-1202-gain-exclusion-amount/
Disclosures:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
All examples are hypothetical and are for illustrative purposes only.
Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information.
Investing in QSBS involves significant risks and potential loss of tax benefits. Qualification requirements are complex and ongoing, including active business, asset composition, and holding period criteria. The company must continuously meet the 80% active business test throughout the investor's holding period. Certain activities and industries are excluded, and exceeding size limitations can disqualify the stock. Early sale before the five-year holding period will result in loss of tax benefits. Insufficient documentation of QSBS status throughout the holding period may lead to disqualification upon IRS scrutiny.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Federal and state laws and regulations are complex and subject to change, which can materially impact your results.
State tax treatment may differ from federal, potentially resulting in unexpected liabilities. Investors should consult with qualified tax and legal advisors to evaluate their specific situation, as QSBS rules are complex and subject to change.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA / SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc.