Recently, a colleague of mine pulled me aside and asked me what I could do to help a 40-year-old client who sold his business last year for $40 million. He wanted to shelter the proceeds from capital gains tax and perhaps set up a trust for his family. We both already knew that the opportunity to reduce capital gains tax recognition had long passed.
If he had asked our opinion long before committing to the sale of this business, we could have explored interesting options. Here are two.
The qualified exclusion of small business stocks
One option our client may have considered is to investigate their business’s qualification for small business stock processing under Section 1202 of the Internal Revenue Code (IRC). Section 1202 was added through the Revenue Matching Act 1993 to encourage small business investment. A qualified small business (QSB) is any active domestic C corporation engaged in certain business activities whose assets have a fair market value not exceeding $50 million at or immediately after the initial issuance of shares, regardless of any appreciation later (IRC § 1202 (d)(1)).
Qualifying small business stocks issued after August 10, 1993 and held for at least five years before being sold may be partially or fully exempt from federal capital gains tax on the value of the stock sold, up to ‘up to $10. million dollars in qualifying gain or 10 times the aggregate cost of the shares sold in each taxable year (IRC § 1202(b)(1)). Please be aware that this limitation applies to each separate shareholder, and a trust, or multiple trusts, established and funded with QSB shares offered by a qualifying QSB shareholder may allow for the exclusion of more than $10 million of earnings. For QSB shares acquired after September 27, 2010, the capital gains exclusion percentage is 100% and is excluded from alternative minimum tax and net investment income tax with the same requirement of five-year detention (IRC § 1202(a)(4)).
But only certain types of businesses fall into the QSB category. To be a QSB, the national society must engage in a “qualified trade or business” (QTB). Such a company will generally manufacture or sell products, rather than providing services and expertise. Businesses that will generally not qualify are those that provide services in the fields of health, law, engineering, architecture, accounting, actuarial, performing arts, consulting , athletics, financial services, brokerage services, banking and insurance, and hospitality businesses such as hotels and restaurants (IRC § 1202(e)(3)).
To qualify and continue as a QSB, the company must follow certain rules (there are many, and these are the most basic): it must be a domestic C company at the time of issuing and selling shares, and at least 80% of its assets must be used in the active conduct of one or more QTBs for substantially all of the five-year holding period. If the business is already an LLC or S corporation, it may still qualify if the business reorganizes and revokes the subchapter S election and issues new shares in the C corporation, then meets the holding period before the sale.
It is essential that the management of the business understands all the requirements of IRC Section 1202 and agrees to maintain the business in a manner that continues to meet the business activity requirement and the limits of investment of assets, and avoid the pitfalls associated with share buybacks, tax elections and conversions.
In summary, for the QSB shareholder to be able to claim the tax benefits upon sale, the following conditions must apply: the shareholder can be a person or a company not organized as a C-Corp; the QSB share must be an original issue and not commercially purchased for other shares; the shareholder must hold the QSB shares for at least five years; and the QSB issuing the shares must devote more than 80% of its assets to the transaction or to one or more QTBs.
The Tennessee Income Tax Non-Granting Trust Strategy
Most states comply with the QSB share exclusion and also exclude capital gains tax on QSB shares when sold as required by IRC § 1202. Exceptions are California, Mississippi, Alabama, Pennsylvania, New Jersey, Puerto Rico, Hawaii and Massachusetts. If you live in one of these states, you may want to consider a competing trust strategy described below to eliminate all capital gains taxes on the sale of QSB shares. But even in compliant states, the QSB shareholder can claim additional exclusions above the $10 million exclusion limit by donating to multiple trusts so that any possible gain from the sale is excluded.
Shareholders living in a non-compliant state or expecting a total capital gain well in excess of the $10 million cap can use a Tennessee Income Non-Grantor Trust (TING) to eliminate all federal and state taxes on the sale QSB shares given to the TING before a sales agreement. Tennessee law allows a person who owns a highly valued asset, such as QSB stock, to reduce or eliminate their resident state’s capital gains taxes when selling the QSB stock through a TING. While several other states also have laws that support this strategy, Tennessee lawmakers have adopted the best parts of other states’ laws. To be clear, a taxpayer already living in a state with no state income tax can use resident state trusts to allocate the capital gain from the sale of QSB stock.
The grantor will donate the QSB shares to one or more TINGs (a donation of QSB shares is an exception to the initial issue rule under IRC § 1202(h)(2) and the five years is not interrupted by a gift to a trust under IRC § 1202(h)(1)). The trustee can then sell the QSB shares in a way that allows them to be treated as a long-term capital gain. If the TING makes no distributions in the tax year in which the qualifying QSB stock is sold, the sale will be excluded from federal and state capital gains recognition.
The Source Income Rule Affecting the Taxation of Trusts
The customer’s resident state may seek to tax at least some of the income of a non-resident TING if the customer’s resident state has a close interest in the assets of the trust, for example through real estate located or a company operating in this State. This is called the source income rule. Some states believe they have sufficient nexus to levy tax on a non-resident trust simply because the settlor or a beneficiary of the trust lives in that state or the trustee has an office in that state. This broad application of the definition of a resident trust may be misplaced, but many of our clients wish to avoid any expense associated with legal action against a state taxing authority.
However, if the tax savings are substantial, a client considering a TING should be aware that the Supreme Court has ruled unanimously that the State of North Carolina exceeded its taxing authority when it sought to tax the income of a trust based solely on the residency of a trust. Beneficiary. North Carolina argued that its taxing authority includes any trust income “for the benefit” of a resident of the state. The Supreme Court disagreed and ruled in North Carolina Department of Revenue v. beneficiaries when the beneficiaries do not have the right to demand this income and are not certain of ever receiving it. This ruling may serve to prevent other state tax authorities from applying too broad an application of their resident trust rule.
These two strategies used together can be very beneficial to a QSB shareholder living in a non-QSB compliant state or one who expects the total capital gain from a sale to exceed the $10 million cap on a QSB capital gain exclusion. However, these strategies also require QSB management and the QSB shareholder to plan several years ahead of any contemplated sale.
Senior Vice President, Argent Trust Company
Timothy Barrett is senior vice president and trust attorney at Silver Trust Company. Timothy is a graduate of the Louis D. Brandeis School of Law, 2016 Bingham Fellow, board member of the Metro Louisville Estate Planning Council, and is a member of the bars of Louisville, Kentucky, and Indiana, and of the University of Kentucky Estate Planning Institute Program Planning Committee.