Recently, one of my colleagues took me in and asked what I could do to help a 40-year-old client who sold his business last year for $ 40 million. He wants to hide the profits from capital gains taxes and possibly fund his family’s trust. We both know that the opportunity to reduce capital gain tax recognition is long gone.
If he had asked for our advice long before he committed to sell this business, we could have explored some important options. Here are two of them.
Qualified Small Business Stock Exclusion
One option our client may be considering is to investigate the eligibility of his or her business for Small Business Stock treatment under Section 1202 of the Internal Revenue Code (IRC). Section 1202 was added through the 1993 Revenue Reconciliation Act to encourage small business investment. Qualified Small Business (QSB) is any active domestic C corporation engaged in certain business activities whose assets have a fair market value not to exceed $ 50 million on or immediately after at the original issue of the stock, notwithstanding the following appreciation (IRC § 1202 (d) (1)).
Qualified Small Business Stock issued after August 10, 1993, and held for at least five years before it is sold may be partially or completely exempted from federal capital gains taxes on the value of the assets. shares sold, to a maximum of $ 10 million in fair profit or 10 times the aggregate cost basis of the shares sold each tax year (IRC § 1202 (b) (1)). Be aware that this limit applies to each separate shareholder, and a trust, or multiple trusts, established and funded by QSB Stock provided by a qualified QSB owner can provide more than $ 10 million without maapil. For QSB shares acquired after Sept. 27, 2010, the capital gain exclusion percentage is 100%, and it is excluded from the alternative minimum tax and net investment income tax with the same five -year retention requirement (IRC § 1202 (a) (4) ).
But only a few types of companies fall into the category of a QSB. To become a QSB, the domestic corporation must participate in a “Qualified Trade or Business” (QTB). Such a business will usually make or sell products, as opposed to providing services and expertise. Businesses that typically do not qualify are those offering health services, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking and insurance, as well as hospitality businesses. such as hotels and restaurants (IRC § 1202 (e) (3)).
To qualify and continue as a QSB, the business must follow certain rules (there are many, and these are the most basic): It must be a domestic C corporation when the stock is issued and when it is sold, and at least 80% of its Assets must be used to actively operate one or more QTBs for the greater part of the entire five -year holding period. If the business is already an LLC or S corporation, it may still qualify if the business reorganizes and withdraws the subchapter S election and issues new stock to the C corporation, then meets the holding period. before sale.
It is critical that the company’s management understands all the requirements of IRC Section 1202 and agrees to conduct business in a manner that continues to meet active business requirements and asset investment limitations, and avoids pitfalls. relating to stock redemption, tax elections and conversions.
To summarize, in order for the QSB owner to claim sales tax benefits, the following must apply: The owner may be a person or business not organized as a C-Corp; the QSB stock must be original issue and not traded for other stocks; the shareholder must hold QSB stock for at least five years; and the QSB issuing the stock must devote more than 80% of its assets to the operation or one or more QTBs.
The Tennessee Income Tax Non-Grantor Trust Strategy
Most states agree to the QSB stock exclusion and also do not include capital gains tax on QSB stock when sold as required by IRC § 1202. The exceptions are California, Mississippi, Alabama, Pennsylvania, New Jersey, Puerto Rico, Hawaii. and Massachusetts. If you live in one of the states, you may want to consider a similar trust strategy described below to eliminate all capital gains taxes on the sale of QSB stock. But even with state compliance, the QSB owner could gain additional exclusives in excess of the $ 10 million exemption limit by providing multiple trusts so that all possible profits from the sale are excluded. .
Shareholders living in a nonconforming state or expecting an aggregate capital gain greater than the $ 10 million cap can use the Tennessee Income Non-Grantor Trust (TING) to eliminate all federal and state taxation on the sale of QSB stock. provided by TING before. in a sale agreement. Tennessee law allows a person who owns a highly valued asset, such as QSB stock, to deduct or eliminate his or her resident state capital gains tax on the sale of QSB stock through a TING. . While many other states also have laws that support this strategy, Tennessee lawmakers have adopted the most extreme aspects of the laws of other states. To be clear, a taxpayer who already lives in a state without state income tax can use the reliance of state residents to spread the capital income resulting from the sale of QSB Stock.
The donor will gift QSB stock in one or more TINGs (a gift of QSB stock is an exception to the original rule of thumb under IRC § 1202 (h) (2) and the five -year period of retention is not interrupted by a gift in a trust under IRC § 1202 (h) (1)). The trustee may sell QSB stock in a manner that allows for treatment as a long-term capital gain. If TING does not have a distribution in the tax year in which QSB stock meets all sales requirements, the sale will not be included in federal and state capital gain recognition.
The Sourced Income Rule Affecting Trust Taxation
The client’s resident state may seek to tax at least some of the income of a non -resident TING if the client’s resident state has a close interest in the trust assets, such as through real property located in or a business operating in that state. This is known as the Sourced Income Rule. Some states assume they have an adequate billing and tax connection to a nonresident trust simply because the settlor or a beneficiary of the trust resides in that state, or the trustee has an office in that state. That broad application of the definition of a resident trust may be misleading, but most of our clients want to avoid any costs from suing against a state tax authority.
However, if the tax savings are large, then a client considering a TING should be aware that the Supreme Court has unanimously ruled that the state of North Carolina violated its tax authority when seeking this tax. trust income based solely on the residence of a trust. beneficiary. North Carolina argues that its tax authority includes any trust income that is “for the benefit of” a resident of the state. The Supreme Court disagreed and ruled in the case of North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust “that the presence of state beneficiaries alone does not empower a state to tax income trust that is not distributed to beneficiaries where the beneficiaries have no right to claim that income and not sure to receive it. ” This ruling could serve to prevent other state tax authorities from applying an overly broad application of their resident trust rule.
Both of these strategies used together can be very beneficial for a QSB shareholder living in a QSB nonconforming state or one who expects the total capital gain from a sale to exceed the $ 10 million cap of a the QSB capital gain exclusion. However, these strategies also require that QSB management and the QSB owner plan several years before any planned sale.
Senior Vice President, Argent Trust Company
Timothy Barrett is a senior vice president and trust counsel at Argent Trust Company. Timothy is a graduate of the Louis D. Brandeis School of Law, 2016 Bingham Fellow, a board member of the Metro Louisville Estate Planning Council, and a member of the Louisville, Kentucky and Indiana Bar Associations, and the University of Kentucky Estate Planning. Institute Program Planning Committee.