Use of trusts for multiple Qualified Small Business Stock exclusions

With the increase in mergers and acquisitions activity in recent years, the qualified small business stock (QSBS) exclusion has gained popularity. While each taxpayer can exclude up to $10 million of gain on the sale of QSBS stock, there are planning techniques that can be used to generate additional exclusions.

The Tax Cuts and Jobs Act in 2017 decreased both corporate and individual income tax rates. The corporate rate was permanently decreased to 21 percent and the highest individual rates were temporarily (through 2025) decreased to 37 percent. After factoring in the 20 percent qualified business income deduction, this created an effective rate of 29.5 percent for qualified business income which generates an 8.5 percent difference in tax rates between individual and corporate income.   

The Biden administration and congressional tax plans could make significant changes to this structure. Included in the various published plans are provisions that would: 

1. Increase corporate rates to 28 percent 
2. Increase the top individual rate and capital gains for high earners to 39.6 percent 
3. Phase out the qualified business income deduction for high earners 

It is unlikely that any of these provisions will make their way through Congress without some negotiation and compromise. However, if enacted these provisions could change the decision that business owners make with respect to how their business is organized for tax purposes. One key in these decision points may be the taxability of cash and other assets when distributed from a corporation. 

For qualified small business stock (QSBS), there is an exclusion of gain limited to the greater of $10 million per taxpayer, reduced by prior eligible gains attributable to the same issuer, or ten times the adjusted basis of stock disposed during the taxable year. In the case of an individual filing a tax return with the status of married filing separately, spouses are required to split the exclusion $5,000,000 per spouse.

The statutory language is silent as to the treatment of married individuals filing a joint return, and additional guidance has not been issued. There is a definitional argument that each spouse could receive a separate $10 million exemption. However, this argument is fraught with ambiguity and would likely require disclosure to avoid potential penalties. Each taxpayer will be required to weigh these arguments in their own individual circumstances to determine which position is correct for them. 

In another article we discussed the ability to multiply these exclusions utilizing a number of different planning techniques. Here we will discuss in more detail a specific planning technique that may allow taxpayers to increase the potential exemption while still retaining some access to the funds.

What is a spousal lifetime access non-grantor trust (SLANT)?

To understand a SLANT let’s first take a high look level at a spousal lifetime access trust (SLAT). A SLAT is an irrevocable trust which is set up by one spouse for the benefit of the other. The trust can be flexible but is typically set up to make distributions to the other spouse and descendants during their life, if needed. On the death of the spouse, the remainder of trust will pass to remainder beneficiaries, often the children of the couple. For federal income tax purposes a SLAT is typically a grantor trust which means the spouse who funded the trust (the grantor) is treated as the owner of the trust and the trust is a disregarded entity for federal income tax purposes. A few common reasons for grantor trust treatment are: 

• The trust income may be distributed for the benefit of the grantor’s spouse without the approval of an adverse party 
• The grantor, in a non-fiduciary capacity, has a power to substitute trust assets with other property of equivalent value   

A SLANT is set up similar to a SLAT but with an important distinction so the trust avoids the grantor trust rules and is a taxpaying, non-grantor trust. To avoid the common grantor inclusion items above this trust will have an individual, who has a vested interest in the trust, consent to distributions and avoid language and powers in the trust agreement allowing the grantor to substitute or have a power over the assets in the trust. 

How can the use of SLANTs multiply the qualified small business stock gain exclusion?

Using a SLANT, a spouse can create a trust that provides distributions, if needed, to his or her spouse while also benefiting chosen remainder beneficiaries. The limitations related to qualified small business stock gain exclusion will now be examined at the trust level to determine the greater of $10 million per-issuer or 10 times the adjusted basis limitation. For taxpayers worried about liquidity or access to funds, distributions from the trust are still available to any current beneficiary, subject to the distribution standard listed in the trust agreement. Let’s look at an example. 

Spouse A and spouse B own 2,000 shares of QSBS, with an exclusion percentage of 100%. The stock has a fair market value of $100 million and a tax basis of $1 million. If they sold the shares without additional planning, their maximum exclusion is $10 million, the greater of $10 million or 10 times basis. This results in a combined $89 million capital gain.   

The spouses decide to take advantage of gift planning, as they currently have much of their gift tax exemption remaining and anticipate the value of the QSBS to continue to appreciate. They want reduce their potential estate tax liability and also their income tax liability. 

Spouse A executes a trust for the benefit of spouse B funding the trust with QSBS. Their child is the trustee of the trust as well as the remainder beneficiary. The trust allows the trustee to make distributions subject to standards of health, education, maintenance and support. During the life of spouse B, he or she may receive funds from their trust. Additionally, spouse A does not retain any power which will treat them as an owner of the trust for federal income tax purposes. In this scenario, the trust will have its own exclusion and be subject to the exclusion limitations independent from spouse A or spouse B. 

Taking the planning a step further, spouse B executes an irrevocable trust agreement for the benefit of grandchildren. The creation of two trusts requires us to consider a myriad of different risks. These include the reciprocal trust doctrine and the possibility that two or more trusts could be combined for income tax purposes. Differentiating the two trusts with respect to assets, beneficiaries, distribution provisions, and documented purposes can help to mitigate these risks. In our example, all these factors have been addressed.

Back to our example, spouse A funded their trust with 300 shares of QSBS stock and spouse B funded their trust with 200 shares of QSBS.  Like in our first example, the trusts basis in the stock is $500 per share. At a future date, when the taxpayers and their trusts sell the QSBS, the stock has a fair market value of $50,000 per share resulting in the following capital gains and possible exclusions: 

In this example, the QSBS exclusion is multiplied such that the taxpayer and their trusts benefit from $29.9M combined exclusion, $19.9M more than if they had done no planning. 

Special considerations

In order for this opportunity to work, the rules relating to QSBS need to be carefully analyzed for your specific fact pattern. Once the determination has been made that a qualifying gain can be excluded, planning can be done to help effectively utilize this exclusion with SLANTs and other irrevocable trusts. Do not wait to plan, with a possibility of tax law changes on the horizon, utilizing gifting to magnify the QSBS gain exclusion may come at a higher cost in the future.