Congress first enacted IRC section 1202 in 1993 to encourage investment in specific types of small businesses by providing an exclusion of certain gain from the sale or exchange of qualified small business stock (QSBS). The original benefits of IRC section 1202 attracted moderate attention, but those benefits were significantly enhanced in subsequent decades, most notably under the Small Business and Jobs Act of 2010.  Today the primary benefit for holders of QSBS is a potential exclusion of 100% of eligible gain on a sale or exchange of QSBS issued after Sep. 27, 2010 (the effective date of the act) and held by a taxpayer for at least five years. This tax benefit is a major advantage for founders and investors in high-growth technology or technology-enabled start-ups that are often backed by venture capital funds, among others.

For most taxpayers, the amount of eligible gain that may be excluded with respect to a single qualified business will be capped at $10 million, collectively for all tax years. But many founders and investors find themselves with QSBS that would generate taxable gain well in excess of that eligible amount—for example, upon a business liquidation. For QSBS holders who are willing to consider estate planning transfers, IRC section 1202(h) provides a tremendous opportunity by extending QSBS benefits to transferees who acquire their QSBS by gift. Qualified gift recipients, such as family members or certain trusts, may be able to claim additional QSBS exclusions on stock that was originally held by a single founder or investor.

This discussion explores the meaning of a transfer “by gift” under IRC section 1202(h) and provides some examples of estate planning strategies that may be particularly attractive to founders and investors who hold QSBS.

Basic Requirements for QSBS Exclusion

Though a full review of the QSBS rules is beyond the scope of this article, the major requirements for obtaining the maximum QSBS exclusion are as follows:

• Original issue requirement. The taxpayer must have received the stock at original issue (i.e., not in a secondary sale) in exchange for money, other property, or services, per IRC section 1202(c)(1)(B).
• Five-year holding period. The taxpayer must have held the stock for at least five years prior to the sale or exchange, per IRC section 1202(b)(2).
• Domestic C corporations only. The issuing company must be a domestic C corporation at the time of issue, at the time of the taxpayer’s sale or exchange, and during substantially all of the taxpayer’s holding period, per IRC section 1202(c)(1)-(2).
• Active business and qualified trade or business requirements. At all times during the taxpayer’s holding period, the issuing company must be actively engaged in a qualified trade or business, per IRC sections 1202(c)(2) and section 1202(e). Disqualified businesses include most professional service firms, finance and investment management businesses, and hospitality businesses.
• Small business requirement. At all times before and immediately after the issuance of the taxpayer’s stock, the corporation’s adjusted basis in its cash and other assets must not have exceeded $50 million, per IRC section 1202(d).
• Disqualifying transactions. Certain redemptions by the company with respect to the taxpayer and others, as well as certain hedging transactions by the taxpayer or a related person, may disqualify stock as QSBS, per IRC sections 1202(c)(3) and 1202(j).

As mentioned above, the typical amount that a taxpayer may exclude is $10 million per issuing company over all tax years. Though less common, under a special rule set forth in IRC section 1202(b)(1)(B), certain taxpayers may be subject to a cap that’s higher than $10 million and based on adjusted basis.

Because the QSBS exclusion applies to each taxpayer separately on a per-issuer basis, multiple shareholders in the same issuing company would be entitled to separate exclusions on their respective eligible gains, and taxpayers who found or invest in multiple eligible companies generally would be entitled to a separate exclusion for each issuing company (subject to aggregation rules regarding controlled subsidiaries).

Most jurisdictions, including New York State and New York City, conform to federal income tax treatment of QSBS, effectively allowing an equivalent exclusion for state and local income tax purposes.  (California, Pennsylvania, and a handful of other states do not follow this federal treatment.)

Tax-Free Transferees and Additional Exclusions

IRC section 1202(h) allows holders of QSBS who received their stock through certain tax-free transfers to “step into the shoes” of the transferring person for purposes of the original issue and holding period requirements of IRC section 1202. Included within this provision are transfers by gift, as well as transfers at death, certain transfers from partnership to partner, and certain nontaxable conversions or reorganizations. Taxpayers who acquire QSBS in a taxable transaction, such as a secondary investment round, do not qualify.

At the same time, there is no rule under IRC section 1202 that aggregates or prorates the eligible amount of QSBS exclusion among a transferring shareholder and qualified transferees. Accordingly, a donor who makes a gift of QSBS, as well as each of the donor’s qualified transferees, should be permitted to exclude QSBS gain up to the eligible amount. This raises the possibility that QSBS that was originally held by a single founder or investor may later qualify for separate QSBS exclusions by multiple transferees who received the stock by gift.

What Constitutes a Transfer by Gift?

Neither the IRC nor the Treasury Regulations provides guidance as to the meaning of transfers “by gift” specifically for purposes of IRC section 1202(h). And there is some disagreement among practitioners about the scope of this provision. For example, this article’s authors have heard arguments that concepts that apply for purposes of the gift tax (such as the requirement of a “taxable” gift or a “completed” gift) must be incorporated into an understanding of IRC section 1202(h). These arguments ignore some major differences between the concept of a gift under the IRC income tax provisions (Chapter 1), of which IRC section 1202 is a part, and concepts that apply for purposes of the gift tax (Chapter 11).

It is well-settled that a donor may make a completed gift of property for gift tax purposes at the same time that the donor continues to be treated as the owner of such property for income tax purposes under the grantor trust rules (IRC sections 671 through 677). This distinction arose in Commissioner v. Beck’s Estate, an early case where a donor sought to avoid gift tax on an irrevocable completed gift on which the donor remained taxable for income tax purposes. The Second Circuit Court of Appeals deftly pointed out: “At the bottom of respondents' contentions is this implied assumption: The same transaction cannot be a completed gift for one purpose and an incomplete gift for another. Of course, that is not true…. Perhaps to assuage the feelings and aid the understanding of affected taxpayers, Congress might use different symbols to describe the taxable conduct in the several statutes, calling it a ‘gift’ in the gift tax law, a ‘gaft’ in the income tax law, and a ‘geft’ in the estate tax law.”

Conversely, the IRS has issued numerous private letter rulings determining that gifts to certain trusts (sometimes referred to as incomplete nongrantor, or ING, trusts) may be considered incomplete gifts for gift tax purposes, but where the donor does not remain the owner of any portion of the trust for income tax purposes. (See, for example, PLR 201908006.)

Speaking more broadly, the IRC income tax and gift tax provisions simply are not in pari materia. In Commissioner v. Duberstein, the Supreme Court addressed the question of which gifts are excluded from a recipient’s gross income by statute and noted that “analogies and inferences drawn from other revenue provisions, such as the gift and estate taxes, are dubious” and that the determination of whether a gift has been made is a factual one, to be determined based on the intent of the transferor.

An interpretation of IRC section 1202(h) should also be consistent with Revenue Ruling 85-13, which stands for the proposition that transactions between a grantor trust and its grantor are disregarded for income tax purposes. That ruling states that where a taxpayer is treated as owner of an entire trust under the grantor trust rules, the taxpayer “is considered to be the owner of the trust assets for federal income tax purposes,” equating ownership under the grantor trust rules with ownership for income tax purposes generally. For this reason, a transfer of QSBS to a grantor trust—whether revocable or irrevocable—should not be viewed as a transfer by gift for purposes of IRC section 1202(h). Under Revenue Ruling 85-13, the donor remains the owner of that QSBS for all income tax purposes, and a sale or exchange of that QSBS should be treated for income tax purposes as a sale or exchange by the donor individually.

There does not appear to be any legislative history expanding on the meaning of transfers by gift specifically in the context of QSBS. But the precise statutory language at issue appears to have originated instead with an early proposal for gain exclusion on investments in federal enterprise zones.  While not controlling, the earlier use of the same statutory language is illuminating because that proposal did not provide any dollar cap on the gain exclusion. It seems illogical, then, that Congress had gift tax limitations in mind—such as a requirement of a taxable gift for gift tax purposes—as a backstop to its statutory definition of transfers by gift.

Based on all of the above authorities, it is the view of this article’s authors’ that a donee who receives QSBS by gift for purposes of IRC section 1202(h) need only satisfy two requirements— 

• that the donor intended, under all the facts and circumstances, to make a donative transfer, and
• that the donee is a taxpayer with an identity separate from the donor for income tax purposes.

Estate Planning Transfers by Gift

With the above definition in mind, founders and investors with large positions in QSBS may wish to consider some of the following gifting strategies to multiply the number of QSBS exclusions available to offset taxable gain:

• Outright gift. A donative transfer of QSBS to a child, parent, or other individual.
• Completed gift to nongrantor trust. A donative transfer of QSBS to an irrevocable nongrantor trust that is a completed gift for gift tax purposes. However, note that under Treasury Regulations section 1.643(f)‑1, two or more trusts will be treated as one if they have “substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries” and if a primary purpose for the transfers was the avoidance of federal income tax.
• Incomplete gift to nongrantor trust. A donative transfer of QSBS to a so-called ING trust, which would be classified as a nongrantor trust for income tax purposes but as an incomplete gift for gift tax purposes. Under the typical structure, an ING trust has domestic asset protection features and includes the donor as well as other permissible beneficiaries, some of whom serve on a distribution committee responsible for authorizing trust distributions. Note, though, that a New York resident who creates an ING trust will be taxed on the trust’s income for New York income tax purposes as if the ING trust were treated as a grantor trust for federal income tax purposes [see New York Tax Law section 612(b)(41)].
• Gift of remainder interest in a grantor retained annuity trust (GRAT). A donative transfer of the remainder interest in a GRAT, if QSBS constitutes a part of the remainder interest and if the recipient of the remainder is an individual or nongrantor trust that otherwise would qualify as a QSBS transferee by gift. Yet, note that a GRAT itself is, by nature, a grantor trust and thus would not qualify for its own separate QSBS exclusion during the GRAT term.
• Gift to charitable remainder trust. A donative transfer of QSBS to a charitable remainder trust.Typically this would be designed as a “Flip CRUT,” in which unitrust payments are payable to one or more individual beneficiaries (including the donor) based on a percentage of the value of the trust’s assets each year, beginning in the year following a triggering event, such as the liquidation of the trust’s QSBS. A qualified charitable remainder trust is exempt from income tax under IRC section 664(c)(1), regardless of its QSBS status. However, the trust’s income is assigned according to tiered categories and classes under Treasury Regulations section 1.664-1(d), which are used to determine the tax character of the unitrust payments in the hands of the individual beneficiary or beneficiaries. Taxable gain generally would be deemed to be received first, but excluded income is also recognized under these rules and should retain its nontaxable character when deemed received by the individual beneficiary or beneficiaries as part of their unitrust payments.

Although this article mentions these estate planning strategies in the context of QSBS, each obviously has planning considerations that go beyond IRC section 1202. Those considerations include liquidity for the founder/investor, gift and estate tax liability, state and local income tax liability, asset protection, and—often paramount—continued management and control of property for the benefit of family members and others. In addition, because many of the strategies require taxable gifts that use a portion of a donor’s lifetime gift and estate tax exclusion amount, early planning is often key to maximizing the potential benefits of IRC section 1202(h) and mitigating the risk of decreases in the value of company stock. If considered at a proper phase in an issuing company’s life cycle, it should also be possible for individuals or trusts to become direct investors in a QSBS-issuing corporation, avoiding IRC section 1202(h) altogether.

We have not attempted to address in this article some other contemporary tax questions that arise in the context of QSBS planning, such as qualification following nontaxable events like distributions in further trust, exercises of powers of appointment, other trust modifications, trust distributions to beneficiaries, or changes in a trust’s grantor trust status. However, many of the authorities described above, as well other income tax principles, provide strong support that qualified transferee status should extend to holders of QSBS following those events.

Implications

The tax benefits of IRC section 1202 are an important consideration for founders and investors in QSBS.  Those who have or may have substantial positions in QSBS should consider transfers “by gift” to maximize the benefits of QSBS exclusion while achieving their other estate planning goals.