Your Next $10 Million Tax-Free Idea
Using the section 1202 QSBS exemption to sidestep taxes.
Congress is presently deliberating over the next major individual tax bill, which must be in place by year end to avoid the Tax Bomb referenced in my previous article. Given recent cost cutting measures, we can expect the next overhaul to be written on an Etch-a-sketch rather than a stone tablet.
A Senate supermajority (60 votes) would be required for a permanent change in law that would add to spending deficits for a period greater than 10 years. Republicans do not have the support with a 53-47 split and there’s little political motivation to make concessions for the 7 additional votes.
It seems likely that we’ll get another bill passed under reconciliation. Alas, the Tax Bomb is only delayed, not diffused. Perhaps this is by design – campaigning against tax hikes is effective strategy, being a major factor in the 2024 election cycle.
You can count on me to detail the upcoming tax bill with colorful enthusiasm as more information comes to light. For now, sit tight.
Fortunately, there are permanent provisions in the tax code individuals can use to offset nasty tax burdens, so long as you’re in the know and qualify. The target demographic being those industrious entrepreneurs and angel investors nurturing America’s next big ideas.
Section 1202 of the Internal Revenue Code, made permanent in 2015 by the ironically named Protecting Americans from Tax Hikes (PATH) Act, allows for a substantial portion of qualifying small business stock sales (QSBS) to be excluded from capital gains tax.
Congress obviously neglected to pass the memo onto local municipalities, who seem to be reassessing property taxes like medieval barons. It must have been selective protection.
Under 1202, QSBS can be exempted from capital gains per individual taxpayer up to the greater of $10M or 10 times adjusted basis (usually original investment). For the shares to qualify, they must be originally issued directly by a C-corporation while the company value was not greater than $50M and must be held for no less then 5 years.
Flexible provisions in the law give rise to creative planning methods known as “stacking” and “packing”. These can be used to maximally flog the IRS with its own rulebook. A rare but joyous opportunity.
Stacking – the exemption cap is per ‘taxpayer’, not per household. Stacking involves combining as many unique tax entities as possible within your influence to ‘stack’ the exemption. (i.e. assign shares to spouse, irrevocable trusts for children, etc.)
Packing – It can be difficult to predict the trajectory of start-up revenues, the value of its shares and its capital needs. Packing entails strategic gifts/assignment of shares with the intent to maximize the QSBS exemption among all shareholders while maintaining a balanced cap table (i.e. stock grants to employees, fresh capital raise).
Before you get too excited, know that this doesn’t apply to businesses in several industries, including:
Financial services (this one is particularly upsetting to me)
Real estate
Professional services (law, engineering)
Farming
Mining
Hospitality
This list isn’t comprehensive, and I recommend you professional guidance for more precision. The law seems designed to specifically encourage building. Think software design, manufacturing and construction. If you’re a hopeful entrepreneur or investor looking to design and build the future, this should be something to investigate.
New businesses are launched every day, most of which without proper planning and execution. To a busy business owner with more balls in the air than hours in the day, details can seem a distraction. But they matter.
Services like Carta can be invaluable to entrepreneurs, especially when coupled with competent financial advisors. Follow the rules and you could walk away with potentially millions more in your pocket.
Good ideas are cheap and can be thought of in the span of a shower. Real value is always found in the execution. A well-executed business idea should include a thoughtfully selected tax plan.
Should you fail to execute properly (or flawlessly with a bad idea), that’s where section 1244 of the IRC comes in. Look it up. Even the IRS will feel sorry for you.
Investment advice offered through National Wealth Management Group, LLC.
The information presented is for educational and informational purposes only and is not intended as a recommendation or specific advice. Consult with your tax professional for tax advice specific to your situation.