Reducing the tax burden of an eventual business sale is a high priority for most entrepreneurs. Fortunately, there’s more than one way to save income and estate taxes, depending on the circumstances. Certain trust vehicles have proven advantageous to those living in high-tax-rate states. Other business owners have found a $10 million savings opportunity by qualifying as Qualified Small Business Stock (“QSBS”) under Section 1202 of the Internal Revenue Code.i
But even those in the start-up community with a working knowledge of QSBS may not fully appreciate its potential. For instance, with appropriate pre-transaction planning, exiting owners may qualify for additional $10 million exclusions. How? If a gift of eligible QSBS stock is made to another taxpayer—such as a family member or certain nongrantor trusts—that stock retains its “original issuance” status and is therefore eligible for its own $10 million exclusion, assuming all other requirements are met.ii
Multiplying the QSBS Exclusion
Let’s revisit the Riveras, who “winged” their way to considerable state tax savings in a previous case study. They still plan to sell their business for $30 million, but this time, we’ll assume their company was structured as a C corporation—rather than a limited liability company taxable as a partnership—when it was first established. As they contemplate their goals, the couple remains intent on securing $250,000 of annual, inflation-adjusted spending while minimizing income and estate taxes.
Since the Riveras structured their business as a C corporation, held their shares for more than five years, and met all other requirements under Section 1202, their stock qualifies as QSBS. That means they can exclude $10 million of gain from the sale of their business, netting them $3.4 millioniii in tax savings.
Could they do better? Our analysis explores several scenarios:
- Scenario A: No additional planning; the Riveras only exclude $10 million of gain.
- Scenario B: The couple gives a $10 million stake in their business to an “incomplete” nongrantor (ING) trust. As a separate taxpayer, the ING trust should be entitled to its own $10 million QSBS exclusion, saving an additional $3.4 million in income taxes. Yet the “incomplete” nature of the gift means the assets held in trust will still be subject to estate tax at the grantor’s death.
- Scenario C: Mirrors Scenario B, except prior to the sale, the couple also makes a “completed” gift of $10 million worth of shares in the business to a separate nongrantor (CNG) trust. This hybrid strategy should shield all $30 million of gain from income tax. In addition, assets held in the CNG trust at the grantor’s death should avoid estate tax.
- Scenario D: Mirrors Scenario B, except the Riveras also give $10 million to a Spousal Lifetime Access Trust (SLAT). As a grantor trust, the grantor must pay all income taxes attributable to the SLAT’s assets—including any gain recognized on the sale of the business. As a result, the SLAT is not entitled to a separate $10 million QSBS exclusion. However, assets held in the SLAT will not be subject to estate tax at the grantor’s death, and the continuing obligation to pay income taxes on behalf of the trust and its beneficiaries will deplete the Riveras’ estate for estate tax purposes.
Quantifying the Outcomes
Upon seeing our analysis, the Riveras were pleasantly surprised to compare the amount of sale proceeds subject to income tax under each scenario (Display, top section of each bar). Scenario C, in particular, stood out. Multiplying the QSBS exclusion through nongrantor trusts provides immediate income tax savings on the sale—but Scenario C layered on an even more significant estate tax benefit by structuring the second nongrantor trust as a completed gift. Essentially, by making both completed and incomplete gifts to nongrantor trusts, the couple has avoided all income tax arising from their exit.
Did the SLAT (Scenario D) add any value? Not as much as using the completed nongrantor trust. That’s because a SLAT is almost always a grantor trust, meaning all taxable items are attributed to the grantor. For that reason, there is no separate QSBS benefit. And at $85.5 million, the net assets the couple would have accumulated in 30 years under Scenario C exceed the $82.0 million in the SLAT by about four percent—without having to rely on another three decades of favorable grantor trust laws.iv
CRUTs Help Overcome the Loss of Control
Although the prospect of completely sidestepping income taxes appealed to the Riveras, they were uncomfortable making irrevocable gifts that could considerably restrict the use and enjoyment of the assets. Could these entrepreneurs capture an additional $10 million QSBS exclusion without forgoing unfettered access?
One potential solution may be contributing $10 million of shares to a Charitable Remainder Unitrust (CRUT). In exchange, the couple would receive an upfront income tax charitable deduction for a portion of the value contributed.v They would also retain the right to receive a fixed percentage of the fair market value of the CRUT’s assets each year (a “unitrust” distribution) for a set term or for life.
Since a CRUT is tax-exempt, the sale proceeds should not be taxable immediately. Instead, periodic distributions will be taxable to the Riveras based on certain “tiered” rules of accounting,vi where the highest-taxed tranches are paid out first. Assuming the CRUT qualifies for a separate QSBS exclusion, $10 million of gain should avoid taxation. On the other hand, if the CRUT is not treated as a separate taxpayer for QSBS purposes, then that $10 million of deferred gain will be taxable to the Riveras over the noncharitable term, which could stretch over their joint lifetimes.
This sounded compelling to the Riveras. They would retain access to the sale proceeds via distributions from the CRUT, while the CRUT may be eligible for its own $10 million exclusion. But since the CRUT pays only a fixed percentage each year, it will take time for those accumulated distributions to exceed the amount the couple would have amassed otherwise. How long? The answer depends on the trust term and payout percentage.
Assuming the CRUT qualifies as a separate taxpayer for QSBS purposes, we project that it will take roughly three years for a CRUT with a five-year term and a 37.5% unitrust payout to generate more personal wealth than our “No CRUT” base case (Display). By comparison, it would take 13 years for a joint-life CRUT with a unitrust payout of 9.3% to surpass the personal wealth generated in our base scenario. Interestingly, the Riveras end up with nearly the same amount of wealth in 30 years—irrespective of the term—and nearly $10 million more than not using the CRUT at all.
Clearly, the CRUT creates more wealth if it captures an additional $10 million exclusion that will be paid out over time. Yet while CRUTs are traditionally designed to stretch the payouts to maximize tax deferral, the opposite may hold true for QSBS-funded CRUTs since there are no realized gains to be deferred. The Riveras aim to qualify the recipient trust as a separate taxpayer for QSBS purposes, while receiving $10 million of tax-free income as quickly as possible.
A note of caution: If the CRUT fails to qualify for a separate QSBS exclusion—or if future tax laws eliminate or reduce the QSBS benefit—a longer noncharitable term generally will prove more protective of the Riveras’ personal wealth.vii A needs-based analysis can help quantify the trade-offs, and thereby mitigate those risks.
Entrepreneurs Have Options—If They Know Where to Look
There are many astute ways for exiting owners to minimize income and estate taxes. The right strategy depends not only on the business owner’s goals and objectives, but on obtaining expert advice well before a deal is on the table. If you are contemplating an exit, talk to your Bernstein financial advisor now to explore which planning strategies might benefit you.
- Andrew Bishop, CFA
- Director—Wealth Strategies Group
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
- Thomas Pauloski
- Senior National Director, Institute for Trust and Estate Planning—Wealth Strategies Group
i Internal Revenue Code of 1986, as amended [hereinafter, “IRC”]
ii See IRC § 1202(h)(1), (2)(A),(B).
iii For purposes of this analysis, we assume that the Riveras reside in a state that conforms to IRC Section 1202 and that eligible gain avoids state income tax at a “flat” rate of 10%.
iv On several occasions, most recently in the Biden Administration’s “greenbook” of Fiscal Year 2023 tax reform proposals, the Democrats have proposed to curtail or eliminate many of the estate planning benefits of grantor trusts, including, for example, a proposal to treat the grantor’s payment of income taxes on behalf of the trust and its beneficiaries as taxable transfers for federal gift tax purposes. See Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, at 42 (March 2022); cf. Rev. Rul. 2004-64, 2004-27 I.R.B. 7 (treating such payments as true obligations, not gifts).
v The income tax charitable deduction is not the total amount contributed, but rather the present value of what is expected to pass to charity at the end of the noncharitable term of the trust. The present value calculation takes into account the value of the contributed assets, the discount rate (based on the applicable “Section 7520 rate”), and the noncharitable term of the trust (either a fixed term of years, or for lifetime trusts, a life expectancy table is used). See IRC §§ 664, 7520, and the applicable Treasury regulations thereunder.
vi IRC § 664(b); Treas. Reg. Section 1.664-1(d)(1)
vii Although many professional tax advisors believe that a CRUT should qualify as a separate taxpayer for purposes of IRC Section 1202, that outcome is not certain. Worst case, a CRUT acts as a hedge: Even if the CRUT fails to qualify as a separate taxpayer, it can spread the taxation of previously deferred gain out over the lifetime of the grantor, or the joint lives of the grantor and grantor’s spouse. Bernstein does not give legal or tax advice, so consult with independent, qualified tax advisors before implementing this strategy.