I. Introduction
Roblox Corporation has become a gold standard for tech startups achieving huge financial success. In 2004, Roblox became the pet project of CEO David Baszucki and co-founder Erik Cassel. The earliest success for the business was its first round of fundraising, in which it raised a relatively modest $560,000. From there, Roblox only picked up speed as it implemented its mission “to bring the world together through play,” which it does by creating an open platform for people who enjoy video games to play games created by developers anywhere in the world. Subsequent rounds of funding raised no less than $1 million, with certain rounds in the nine-figure range. The continued success of Roblox led to an initial public offering, valuing the company at $29.5 billion and generating significant returns for its earliest investors.
Roblox’s significant stock appreciation from its formation through its sale on public markets has made Mr. Baszucki, who continues to run the company, a billionaire. If he, or any other early investors, decided to sell the shares received when the stock was worth very little, then the gains would generally be taxed at the 20% capital gains rate. Fortunately for Mr. Baszucki, section 1202 allows taxpayers to exclude specific amounts of gain on the sale of investments in certain small businesses. Due to the nature of Roblox, the earliest shares of the corporation’s stock qualify for the section 1202 exclusion and allow the shares’ owners to exclude from their taxable income $10 million in gain from the shares.
Up through this point, section 1202 appears to work as intended, in that an early investor receives a tax benefit for investing in a small business and is allowed to decrease his or her tax bill by a relatively small $2 million. Section 1202’s benefit does not stop there, however. In what has been dubbed “stacking” the section 1202 benefit, the earliest investors in small businesses eligible for section 1202 treatment can multiply their tax benefit by transferring stock to family, trusts, or other closely-related parties. In fact, Mr. Baszucki was able to multiply the tax break at least a dozen times through the use of this stacking loophole. What would have been a $2 million tax break becomes a $24 million windfall afforded to an individual (and his or her relatives) for no increase in that individual’s initial investment. Early investors in other now-massive tech companies such as Uber, Airbnb, and Zoom have joined Mr. Baszucki in utilizing qualified small business stock (QSBS) stacking. This aggressive tax planning strategy has become increasingly popular, especially for investors in startup tech companies, while receiving increased scrutiny from the media and politicians.
This Article discusses section 1202 stacking and argues that the stacking loophole should be closed. Part I of this paper discusses the history of section 1202, including the motivation behind its enactment and amendments. Part II examines how taxpayers use section 1202 and other sections to create the section 1202 stacking effect. Part III shares the author’s proposals to close the loophole and a discussion of some of the other noteworthy issues surrounding section 1202. Finally, Part 0 will conclude this Article.
I. The History of Section 1202
Since its inception, section 1202 has provided different levels of benefits for taxpayers. The following subsections discuss (i) the creation of the provision in 1993, (ii) the subsequent temporary increases of the section 1202 exclusion, and (iii) the permanent changes made in 2015.
A. Omnibus Budget Reconciliation Act of 1993
In 1992, Bill Clinton ran on a platform that included support for small businesses. The Democratic Party won the 1992 elections, winning the Presidency and both houses of Congress. The Democratic Congress enacted the Omnibus Reconciliation Act of 1993, also known as the Deficit Reduction Act of 1993 (the 1993 Act), to decrease the expected federal deficit for fiscal years 1994–1998. The 1993 Act included the original section 1202. Other provisions of the 1993 Act received significant criticism from Republicans for their potential to injure small businesses and small business investment through income tax hikes. Democrats countered this criticism by highlighting provisions such as section 1202 to argue that the bill provided most small businesses with a tax cut. Democrats thus championed the targeted capital gains tax cut provided by section 1202 as a way to increase small business investment and stimulate economic growth. For instance, the House Budget Committee believed that the section would provide “targeted relief for investors who risk their funds in new ventures . . . [and would] encourage investments in [small businesses].” The committee further stated that the capital gains exclusion rules would “encourage the flow of capital to small businesses . . . .” President Clinton further endorsed the idea that section 1202 was designed to increase capital invested in small businesses by giving a 50% tax cut for investments in “new and small businesses.”
The version of section 1202 enacted in 1993 allowed non-corporate taxpayers to omit 50% of gain on the sale of stock in certain small businesses from their gross income. The exclusion applied only to investments in businesses with less than $50 million in capital and required owners of the stock to hold the investment for five years before receiving the benefit. These general rules have seen minimal changes by Congress; the Treasury and the Service have done little to further interpret them.
When Congress originally enacted section 1202, the long-term capital gains rate was 28%. Using section 1202, taxpayers could decrease that 28% capital gains tax on gain from QSBS to 14% due to the ability to exclude 50% of QSBS gain in the year of sale. The benefit was still subject to the alternative minimum tax (the AMT), which would have decreased the benefit of the QSBS exemption for those to whom the AMT applied. But generally speaking, at the end of the day, a taxpayer could save 14% on their gain from QSBS by utilizing section 1202.
The section 1202 rules were not without criticism. After implementation, one entrepreneur argued before Congress that section 1202 was not working as intended due to the built-in limitations to the general rule and the application of the AMT to investors. The entrepreneur’s proposals would have weakened the limitations and increased the benefit of section 1202 in ways he argued would stimulate venture capital investment. Throughout the section’s history, many have similarly argued for higher limitations and greater exclusion percentages.
B. Temporarily Increased Section 1202 Exclusion
In 1997, Congress decreased the rate on most capital gains from 28% to 20%. Congress again decreased capital gains rates in 2003 to 15%. In each instance, the rate that applied to QSBS gains remained 28%. Because the QSBS exclusion decreased the effective tax rate to 14%, the capital gains rate decrease to 20% lowered the section 1202 benefit from 14% to six percent (20% capital gains rate minus 14% section 1202 rate). The subsequent 15% capital gains rate further lowered the benefit to one percent (15% capital gains rate minus 14% section 1202 rate). The decreases in capital gains rates led to a weakened section 1202, which received increased criticism for its lack of success in stimulating small business investment.
In 2009, in an effort to stabilize the economy after the Great Recession, Congress temporarily increased the section 1202 exclusion to 75% (up from 50%) of the gain from the sale of QSBS acquired after the date the law was enacted through the 2010 taxable year. The increased exclusion brought the effective tax rate for QSBS from the original 14% down to seven percent (one minus the 75% exclusion multiplied by the 28% QSBS capital gains rate). Compare this new seven percent effective rate to the decreased individual capital gains rate of 15%, and taxpayers were able to get an eight percent benefit from QSBS versus the previous one percent benefit.
C. Permanently Increased Section 1202 Exclusion
Congress again temporarily increased the section 1202 exclusion by passing the Small Business Jobs Act of 2010 (the 2010 Act). Congress put forward the bill to provide small businesses with increased access to lending and tax incentives designed to help them grow in the wake of the Great Recession. This temporary increase to the exclusion amount allowed investors in QSBS to exclude 100% of gain on the sale of the stock acquired after the enactment of the 2010 Act and before 2011. For stock acquired within that window, taxpayers would receive a benefit equal to the otherwise-applicable capital gains rate, as they would not be required to pay any taxes on the gain.
Congresswoman Allyson Schwartz addressed the House of Representatives after the passage of the 2010 Act to praise its enactment. The Congresswoman stated that the 2010 Act would help small businesses by expanding incentives for capital investments, among other things. Others in the House likewise supported the increased exclusion amount by arguing that it would allow “formation of new businesses and allow small businesses to grow and hire more workers.” This temporarily-increased exclusion in support of small businesses set a precedent that Congress would later extend.
Further laws extended the temporary 100% gain exclusion both retroactively and prospectively, but as of 2015 the exclusion had yet to be made permanent. At the end of 2015, Congress enacted the Consolidated Appropriations Act, which included the Protecting Americans from Tax Hikes Act (the PATH Act). The PATH Act permanently increased the section 1202 exclusion to 100%. The PATH Act did this rather unceremoniously while making adjustments to other provisions in the Code.
The Tax Cuts and Jobs Act of 2017 (TCJA) increased the relevance of section 1202 by reducing corporate tax rates. Before the TCJA, corporate taxpayers paid a marginal rate of 15% on the first $50,000 of income, increasing up to 35% for income over $18,333,333. These relatively high rates, combined with double taxation upon distribution of corporate profits, made the corporate structure less enticing compared to a flow-through entity with a single level of taxation. When the TCJA permanently slashed the corporate rate to 21%, some taxpayers adjusted to the corporate structure and eventually began to increase planning around the section 1202 benefit.
Throughout its history, Congress has justified section 1202 for its ability to stimulate small business growth and provide access to capital. There has been some rhetoric surrounding section 1202 about decreasing taxes on small business owners, but that, too, is often draped in language supporting the investment and growth in the small business sector.
II. How Section 1202 is Used Today
For a taxpayer to gain the full benefit of section 1202, multiple tax rules come into play. To illustrate how this works, the following subparts discuss (i) section 1202’s general requirements, (ii) section 1202’s per-issuer limitations, (iii) the relevant transfer rules of QSBS, and (iv) the end result which is section 1202 stacking.
A. Section 1202’s General Requirements
The general rules are relatively simple. A non-corporate taxpayer must hold the stock for five or more years, the investment in the small business stock must be QSBS, and the small business corporation must have an active business.
1. Five-Year Rule
The five-year rule is clear: to receive the tax benefit a non-corporate taxpayer must hold its stock investment in the small business for at least five years before selling (or exchanging) it. Generally, the taxpayer’s holding period begins on the date the qualifying small business issues the stock to the taxpayer. After the taxpayer holds the stock for five years, the section 1202 rules may apply if all other requirements for QSBS treatment are met. The rules are available to any “taxpayer other than a corporation,” which allows for significant flexibility in tax planning, for example through the use of trusts.
The taxpayer may also benefit from a previous shareholder’s holding period in the event of a tax-free transfer. If a taxpayer received the QSBS in a tax-free transfer, the rules consider the taxpayer to have acquired the stock in the same manner and at the same time as the previous owner. This is a taxpayer-friendly addition to the rule, which could potentially lead to a significant shortening of the taxpayer’s required holding period by allowing the taxpayer to tack on the previous owner’s holding period in the case of a gift or other tax-free transfer. This Article further explores tax-free transfers and their implications to QSBS in Part III.C.
2. Qualified Small Business Stock
The second general rule requires a bit more nuance. Section 1202 defines QSBS as “any stock in a C corporation” issued after the 1993 Act if (i) the stock is of a qualified small business and (ii) the stock is acquired at its original issue in exchange for money, property, or as compensation for services provided directly to the corporation. The Code defines a qualified small business as a domestic C corporation with aggregate gross assets less than $50 million at all times before and immediately after issuance of the stock, provided that the corporation agrees to submit relevant reports to the Treasury and shareholders to carry out the terms of the section. The following subparts will discuss the major components that make up the definition of QSBS.
a. Qualified Small Business: Aggregate Gross Assets Before Issuance. The Code requires that a corporation have aggregate gross assets of less than $50 million at all times before the issuance of its potential QSBS. Further, the Code defines aggregate gross assets as the total cash and aggregate adjusted bases of property held in the corporation. For the calculation of aggregate gross assets, property contributed to the corporation is treated as if it had a basis equal to its fair market value at the time of contribution. This differential between fair market value and basis can lead to issues for future investors. Because the aggregate gross assets of the corporation are determined by each asset’s fair market value at the time of contribution, a contribution of significantly appreciated property could leave the corporation much closer to the $50 million cap than the corporation’s inside basis would show, which could leave investors without section 1202 treatment. Further, a taxpayer cannot skirt the aggregate gross assets rule through ownership of a subsidiary, since a parent and its subsidiary(ies) are treated as a single corporation if the parent owns 50% or more of the subsidiary(ies).
Alternatively, the definition of aggregate gross assets can be advantageous for investors. Because the calculation is based on the basis of assets (other than assets that appreciated before contribution, which fall under the fair market value rule discussed above), property that appreciates within the corporation can increase the corporation’s value without pushing the corporation above the $50 million limit. As long as the corporation does not trigger a step-up in basis on assets within the corporation, the corporation can be worth significantly more than the limit before triggering the limitation. The implied equity valuation of a corporation based on the purchase price of its stock does not weigh into the aggregate gross assets calculation, which allows corporations worth well over $50 million to receive QSBS treatment.
Unfortunately for investors, Congress, Treasury, and the Service have yet to clarify the meaning of “at all times.” In situations where contributions to the corporation put aggregate gross assets over the threshold, the logical result would be that section 1202 treatment is no longer available to the corporation. The correct result becomes less clear when a corporation sells an appreciated asset at a gain (generating cash) that would temporarily put its aggregate gross assets above the $50 million max. For example, a corporation with $40 million in business assets sells $11 million in investment assets that have a $1 million basis, forcing the corporation to have adjusted gross assets of $51 million before paying taxes on the $10 million in gain. After paying approximately $2 million in taxes on the gain, the corporation will have adjusted gross assets of $49 million. This hypothetical has led to some confusion about whether the “at all times” requirement is violated by temporary increases in adjusted gross assets.
b. Qualified Small Business: Aggregate Gross Assets After Issuance. The other half of the aggregate gross assets test requires that a corporation have less than $50 million in aggregate gross assets immediately after issuance of potential QSBS. The rule further states that the aggregate gross assets test includes the amount of cash or property received in exchange for the issuance of stock. Taxpayers must also be wary of the potential application of the step-transaction doctrine in the case of multiple rounds of funding. Planned rounds of funding that will eventually increase aggregate gross assets above the $50 million threshold may be treated as a single transaction, which could disqualify QSBS treatment for the earlier rounds of funding below the threshold amount. Failure to meet this requirement results in the corporation’s stock not receiving any QSBS treatment—that is, there is no phaseout or forgiveness built into section 1202.
c. Acquisition of Stock at Original Issuance. The final major component of the QSBS and qualified small business definitions requires that the taxpayer acquire the stock at its original issue in exchange for money or other property or in exchange for services. The taxpayer may acquire the stock directly or through an underwriter. The section also provides the same treatment whether he or she acquires the stock with cash, other property (other than stock), or as compensation for services provided directly to the corporation.
There are noteworthy exceptions to the original issuance rule. First, certain stock-for-stock transactions, both for different types of stock in the same corporation and for stock in two different corporations that qualify for QSBS treatment, may still receive QSBS treatment. A taxpayer will not be eligible for QSBS treatment, however, if, within a certain amount of time before or after the issuance, the corporation redeemed any of its stock from the taxpayer or a related person. The second exception is the tax-free transfers rule, discussed in detail in Part III.C.1. In either event, the taxpayer is allowed to tack the previous owner’s holding period in the stock received for purposes of QSBS treatment.
3. Active Business Requirement
The Code further requires that the qualified small business be engaged in an active trade or business during “substantially all” of the taxpayer’s holding period. To meet the threshold of an active business, the small business must utilize at least 80% of the value of its assets in a qualified trade or business, and the corporation must be an eligible corporation throughout the holding period.
The 80% value requirement has a few issues that a taxpayer should note. For one, working capital that is required to meet the needs of a qualified trade or business is treated as actively used in that qualified trade or business. Investments in stock, except for stock in 50%-owned subsidiaries, that exceed ten percent of the corporation’s assets will lead to the small business failing the active business requirement, however. Additionally, a small business may not own real estate greater than ten percent of its assets, or it, too, fails the active business requirement. The section is also generous to tech businesses by treating rights to computer software as active business assets if they generate active business computer software royalties within the meaning of section 543(d)(1).
The Code limits the types of businesses that are considered a qualified trade or business, effectively closing off the benefit to certain industries. Services businesses like law or accounting, financial services and banking, farming, mineral extraction, and hospitality, to name a few, are all prohibited from utilizing the QSBS benefit because they are not qualified trades or businesses. Regardless, the rules do allow for significant flexibility with intentional business planning, and the Service has taken a broad stance on the scope of qualified trades or businesses. The Service has published private letter rulings on the subject of qualified trade or business in the context of section 1202. One found that a pharmaceutical company’s business of commercializing experimental drugs was not excluded as a health service, and the other came to the same conclusion for a medical tool developer. The Service’s stance in this regard seems very taxpayer-friendly, and this generous position could well apply to other sectors of the economy.
Only after satisfying all of the above requirements can a taxpayer safely determine whether shares are QSBS. The next step is to determine the amount of the benefit afforded to the taxpayer as a result. As discussed earlier, the original exclusion allowed a taxpayer a 50% deduction on the gain on sale of any QSBS. Subsequent iterations of the rule allowed higher exclusions leading up to the current exclusion of 100% of gain on sale of QSBS. On its own, this would allow the taxpayer to avoid taxes on any gain from QSBS by excluding 100% of the gain from the taxpayer’s gross income. The Code, however, prevents limitless exclusion of gain through the per-issuer limitations, as described immediately below.
B. Per-Issuer Limitations
The per-issuer limitations prevent unfettered tax avoidance by limiting the amount that a taxpayer can exclude for each qualified small business investment. The taxpayer is allowed to exclude the greater of (i) $10 million of QSBS gain or (ii) ten times the aggregate adjusted bases of QSBS issued by the corporation to the taxpayer and sold or exchanged by the taxpayer during the relevant taxable year.
1. Cumulative Limitation
The $10 million rule, sometimes referred to as the cumulative limitation, gives taxpayers the ability to exclude $10 million in gain without regard to the amount of basis in the shares. The cumulative limitation rule prevents taxpayers from reusing stock in the same qualified small business annually by forcing the taxpayer to reduce the $10 million cap by the amount of gain excluded from income in the taxpayer’s prior taxable years. Fortunately for married taxpayers that file jointly, the prevailing theory is that each individual may exclude the entire $10 million, potentially allowing a couple to exclude a total of $20 million in gain. The gain, in this case, is allocated equally between the two married individuals.
For example, if a taxpayer purchased 100 shares of QSBS in Year One for $100,000 and disposed of one-half of it in Year Six for $6 million, the taxpayer would be able to exclude from gross income in Year Six $5.95 million ($6 million amount realized minus $50,000 in basis attributable to the one-half of shares sold). If the taxpayer sold the other half of the QSBS in Year Seven for an additional $6 million, the taxpayer would have to reduce the $10 million cap by the previous year’s $5.95 million down to $4.05 million. This would allow the taxpayer to exclude only $4.05 million of Year Seven’s $5.95 million gain ($6 million amount realized minus $50,000 in basis attributable to the sale). The overall result is the taxpayer reduced his or her gross income related to the sale of the QSBS by $10 million.
Since the rule is applied on a per-issuer level, a taxpayer holding QSBS in two or more corporations may exclude more than $10 million in income in any given year by investing in multiple businesses. For example, if the taxpayer owns QSBS in Corporations A and B, both with a basis of $100,000, then the taxpayer could sell each set of QSBS for $10.1 million and take the full $10 million exclusion for gain attributable to both Corporation A and B’s stock. In this hypothetical, the taxpayer can multiply their tax break through increased investment in qualified small businesses, which generally seems in line with the goal of section 1202 as discussed in Part I.
Founders and their early employees are likely to benefit more from the cumulative limitation than the annual limitation discussed below. Such individuals often put little to no capital into the business, instead receiving shares as compensation for services rendered at a time when the value of the business is relatively low. Accordingly, such individuals will likely have a low basis in their shares, making the cumulative limitation comparatively more valuable than the annual limitation. In this way, the cumulative limitation may provide significant tax advantages to founders (and early key employees that receive equity) with little capital at risk in the venture.
2. Annual Limitation
The other limiting rule, the annual limitation, allows the taxpayer to exclude up to ten times his or her aggregate adjusted bases in the QSBS. The cost basis of any individual QSBS follows the Code’s general basis rules set out in Subchapter O. In general, the taxpayer’s basis in the QSBS will be the amount for which the taxpayer purchased the shares. The limitation is then calculated by multiplying the stock’s cost basis by ten. In the examples above, where the taxpayer had a basis of $100,000 in the stock, this limitation would allow the taxpayer to exclude only $1 million from gross income. Fortunately, the ultimate limitation is based on the greater of the cumulative or the annual limitation, which allows the earlier taxpayer to receive a $10 million exclusion through the cumulative limitation.
The annual limitation rule allows early capital investors in QSBS, who often make large contributions to capital, to receive significant exemptions for their potential future gain. For example, a venture capital partnership that invests $10 million into a qualified small business corporation would receive a stock basis equal to its investment in the corporation. After fulfilling the other QSBS requirements, the partnership’s investors, in the aggregate, would be allowed to exempt up to $100 million ($10 million aggregate basis in the QSBS multiplied by the statutory multiplier of ten) in gain on the stock under the annual limitation. A savvy investor is likely to request information to discern whether his or her stock purchase will be eligible for QSBS treatment and may be more likely to invest in a high-risk small business due to the potentially higher returns from QSBS treatment.
As one can see, this exclusion can create a powerful incentive for early capital investors in a qualified small business. The annual limitation may expand small businesses’ access to capital through the incentive for early investors to invest as much capital as possible in the stock to expand the gain exclusion. By contrast, the cumulative limitation, as it is currently interpreted, can lead to significant tax windfalls for founders, their families, and other early investors who risk relatively little (or even zero) capital but still can receive a $10 million exclusion.
C. Transfers of QSBS
On its own, section 1202 is a powerful benefit that allows investors in small businesses to decrease their tax bills on any gain, which hopefully incentivizes increased investment in small businesses. But taxpayers can significantly increase the QSBS benefit through a strategy known as “stacking,” which allows investors (often small business founders) to multiply the benefit through tax-free transactions to related or trusted individuals (as well as trusts). The following subparts will discuss two aspects of the QSBS stacking strategy: (i) the section 1202 tax-free transfers rule, and (ii) the section 2503 taxable gifts.
1. Tax-Free Transfers
The Code gives specific benefits to individuals (and certain trusts beneficially owned by such individuals) who receive QSBS in tax-free transfers relative to individuals that acquire QSBS from the original holder in taxable transactions. Suppose an individual owns stock that could potentially meet all the requirements of QSBS but sells it before he or she has met the five-year holding requirement. The seller in this scenario is not afforded any QSBS benefits, and section 1202 no longer applies to the shares since the purchaser acquired the shares in a taxable transaction. As such, the purchaser cannot exclude any gain on the subsequent sale of those purchased shares through section 1202’s rules. The Code clearly states that the stock in the hands of the purchaser is not QSBS because the purchaser did not acquire the stock at issue. The purchaser will have to rely on the normal basis and gain rules when he or she eventually disposes of the stock.
Unlike a purchaser of QSBS, an individual who receives the shares from the original holder through a tax-free transfer is treated as if he or she acquired the shares at original issuance from the corporation. The Code treats the transferee as having received the stock in the same manner as the transferor. The Code also allows the transferee to include the transferor’s holding period in his or her five-year holding period calculation. For example, if a founder acquires potential QSBS at the onset of the business, holds it for three years, and then transfers it to another individual in a tax-free transaction, then the transferor need only hold the stock for an additional two years before the section 1202 gain exclusion applies to the stock. Since the transferor is treated as having received the stock in the same manner as the transferor, there are no concerns relating to the issuance requirement. The transferee will simply receive the transferor’s carryover basis in the stock.
The Code provides that transfers by gift and at death of a grantor may receive this treatment. The transfer of stock as a gift is the primary tool of stacking and is discussed in the following subpart. The death benefit is unlikely to receive the same public scrutiny as the gift benefit, because it is less likely to be used as a short-term tax planning tool. Section 1202’s tax-free rule also applies to certain contributions and reorganizations, as well as partnership-to-partner transactions, with special requirements for each, but such transfers are not relevant to stacking and are not the subject of this Article.
2. Taxable Gifts
In an effort to limit the potential issue of taxpayers avoiding estate taxes through aggressive donations, the Code taxes, under rules similar to the estate tax rules, all gifts that exceed certain exclusion amounts. Section 2503 defines “taxable gifts” as “the total amount of gifts during the taxable year.” There are a few exceptions to this rule, and one relevant exclusion to section 1202 stacking is the annual exclusion. The annual exclusion for 2022, as adjusted for inflation, treats the first $16,000 of gifts given to an individual as non-taxable. (For the years 2018-2021, the annual exclusion was $15,000.) Taxable gifts include gifts of cash or property. Amounts over the statutory annual exclusion are not necessarily subject to tax, however.
In addition, the Code provides a lifetime donation cap, in the form of a “unified” basic exclusion from gift and estate tax, after which gifts become taxable to the donor. Before the TCJA, the lifetime exclusion was an inflation-adjusting $5 million in gifts over a taxpayer’s lifetime. The TCJA increased the lifetime exclusion to an inflation-adjusting $10 million through 2025. Since the TCJA, it has increased significantly due to inflation, bringing the 2022 lifetime exclusion to $12.06 million per individual taxpayer. The lifetime exclusion is, however, scheduled to return to pre-TCJA levels for 2026 taxable years and beyond. Further, the TCJA increases are under some recent scrutiny. Early versions of the Build Back Better Act (later enacted as the Inflation Reduction Act of 2022) would have struck the TCJA increases, leading some practitioners to advise their high-net-worth clients to give gifts sooner rather than later.
It is worth noting that there was some concern that the Treasury would attempt to claw back any gifted amounts over the pre-TCJA levels when the exclusion returns to the original amount. The Treasury replied to these concerns with a proposed regulation that prevents clawback for individuals if the amount of gifts given during the taxpayer’s life was higher than the exclusion at time of death, provided that the taxpayer gifted at the higher exclusion level when it was law.
The annual and lifetime exclusions work together to determine a taxpayer’s gift tax burden. The annual exclusion treats the first $16,000 (for 2022) in gifts for the year as a non-taxable amount, and any amount over that threshold is taxable. The donor will then receive an exclusion (in the form of a credit) equal to the lesser of the amount of the taxable gifts given and the amount of lifetime exclusion the donor has not used. The lifetime exclusion available for future years is then reduced by the amount of the exclusion used by the taxable gift. When an individual’s lifetime exclusion runs out, he or she will be limited to the annual exclusion to avoid taxation on any future gifts and, upon death, the estate will generally have to pay taxes on the entirety of the estate before disbursing any assets to its heirs.
The final aspect of the gift-giving regime is a basic taxation concept. In general, an individual who receives a gift (i.e., the donee) takes the same basis the donor had in the property prior to the making of the gift. A possibly relevant exception is that gift taxes paid on any gifts increase the donee’s basis. But because gift taxes will only apply when the donor has reached his or her lifetime exclusion, it is unlikely for this exception to apply in most circumstances.
As an example of the above concepts, suppose that a high-net-worth taxpayer gives Individual A $20,000 in cash as a gift and gives Individual B $20,000 worth of shares with a basis of $1,000. Assuming 2022 exclusion amounts, the donor excludes the first $16,000 of the gifts from his or her taxes for each of Individuals A and B. Assuming the donor has a sufficient lifetime exclusion remaining, neither gift will incur gift taxes despite the taxable portions of the gift. The donor will have an $8,000 ($4,000 for each of Individuals A and B’s taxable gift received) decrease to his or her lifetime exclusion cap. The basis in Individual A’s cash will be the amount of cash received. Individual B, on the other hand, receives the basis that the donor had in the property ($1,000). If the donor did not have any lifetime exclusion balance left, then Individual B would increase his or her basis in the stock by the amount of taxes paid on the gift. In this case, a tax rate of 40% on the gift paid by the donor would increase B’s basis in the stock by $1,600 ($4,000 gift times 40% tax rate). The recipient’s step-up in basis may decrease the amount of potentially QSBS-eligible gain realized on the later sale of the stock, at the expense of gift taxation. Taxpayers can avoid this result by gifting shares early, when they are (presumably) not worth much, so the donor does not reach the lifetime limitation.
D. Section 1202 Stacking
The interaction between QSBS, section 1202’s tax-free transfers provision, and gift taxation leads to the novel tax planning strategy of section 1202 stacking. The basic principle is for the original purchaser of QSBS to multiply his or her tax benefit by increasing the number of individuals who can take the QSBS income exclusion.
To illustrate how the rules come together, picture a founder of a small technology business. At the onset of the business, the founder puts in $100,000 cash in exchange for 100% of the C corporation’s stock. The founder receives a basis of $100,000 in the shares. After some time developing a workable idea, the founder reaches out to venture capital firms to receive funding for the project. One venture capital firm decides to invest $10 million in the corporation in exchange for 40% of the corporation’s stock, leaving the founder with the remaining 60% of the stock. The venture capital firm receives a $10 million basis in its newly acquired shares. Due to the relative risk of the startup business, the venture capital firm structures its investment through a special purpose vehicle taxable as a pass-through entity, such as a partnership, thus allowing direct or indirect individual investors in such partnership to take advantage of the QSBS rules.
Ignoring other potential events, the founder leads the corporation to a $500 million IPO after five years. Assuming the percentage ownership remains unchanged, the venture capital firm’s investors now own $200 million worth of shares through the partnership. If the venture capital firm decides to divest from the business and sells its shares at the then-current market value, the partnership would realize a $190 million gain ($200 million fair-market value minus $10 million in basis). Without the QSBS rules, the venture capital firm’s investors would presumably pay taxes on the full $190 million gain, but assuming the C corporation met all the QSBS requirements, the venture capital firm’s investors may utilize the beneficial QSBS rules. That is, each of the individual investors are allowed to exclude up to the greater of the cumulative limitation or the annual limitation. In this case, the annual limitation gives the investors as a whole an aggregate $100 million exclusion ($10 million basis times ten), while the cumulative exclusion would give each investor up to a $10 million exclusion. The QSBS rules thus allowed the venture capital firm’s investors to exclude a significant amount of gain. The firm may not have invested in the business without the QSBS tax incentive to compensate for the risk.
The founder’s shares are worth a total of $300 million (60% of $500 million). If the founder also sells his or her shares, the founder is similarly allowed the greater of the cumulative or annual limitations. Since the founder’s basis in the shares is $100,000 from the original issuance of the stock, the annual limitation is $1 million ($100,000 basis multiplied by ten).
Without any additional tax planning, this leaves the founder with a single $10 million limitation against almost $300 million of taxable gain. If the founder were to sell all his or her shares, there would be almost $290 million of taxable income. As noted above, the cumulative limitation does not reset annually, so the founder does not have a way to decrease the gain over time.
With astute tax planning, however, the founder will transfer shares to related individuals as gifts. This is often seen as a transfer to the founder’s spouse and children (or trusts for the benefit of the children). Since individuals who receive the shares are treated as having received the shares at issuance, they can use the QSBS gain exclusion at the same time as the founder, effectively multiplying the benefit by the number of individuals who receive QSBS gifts from the founder. That is to say, a founder who transfers shares with zero basis to four other individuals has effectively created an additional $40 million in total QSBS gain exclusion in addition to the founder’s own $10 million gain exclusion. The benefit here is limited by the gift tax and its annual and lifetime gift-giving caps. If the founder gifts the shares when the value of the shares is $300 million, then the cap is quickly met by a transfer of $10 million to two individuals (recall that the lifetime gift-giving cap is $12.06 million for 2022). The founder can only get an additional $12.06 million excluded from taxation by splitting the gifts over two (or more) individuals. This leaves the founder and related individuals with taxable gain of $276.84 million ($300 million fair-market value of shares, minus $100,000 basis, minus $10 million QSBS exclusion for the founder, minus $12.06 million QSBS exclusion benefit effectively gifted between two individuals).
The founder can increase the benefit with some foresight. Instead of transferring the shares when they reach their IPO value, the founder can transfer the shares when their value is low. At the IPO, $10 million worth of shares was equivalent to 2% of ownership in the corporation ($10 million QSBS individual limitation divided by $500 million IPO valuation). When the venture capital firm joined the equity mix, the valuation of the company was presumably $25 million ($10 million price paid by venture capital firm divided by 40% share acquired by the firm). At the time of the venture capital funding, the founder could gift related individuals 2% of the total shares, valued at $500,000 each, 24 times and still have just under $100,000 left in the founder’s lifetime gift exclusion. It is improbable that a founder has 24 related individuals that would be worth transferring shares to, not to mention the fact that the founder’s ownership share would be significantly diluted as a result, but it is at least theoretically possible to structure a transaction in this fashion. Still, in a family of five individuals, the founder can multiply the benefit to $50 million ($10 million QSBS lifetime exclusion times five gift-receiving taxpayers, including the founder) and only use up $1.936 million of the founder’s lifetime gift-giving cap ($500,000 gifts multiplied by four gift-receiving taxpayers in the family minus the annual limitation of $16,000 per donee). With more related individuals (or the usage of trusts), the tax benefit increases significantly, and nothing would prevent the founder from making gifts outside of the family unit (other than the diminution of family control).
As one can see, a founder with intentional tax planning and related individuals can multiply the QSBS benefit many times without an increased investment or risk. This founder’s benefit may arguably incentivize individuals with risky ideas to attempt them in the hopes of a significant pay-off, which may be in line with Congress’ goal of stimulating small business. Still, it would seem unlikely that an individual would actually know enough about the particulars of the Code to include section 1202 stacking in his or her plan from the beginning. It seems more likely that stacking presents an unintended windfall to founders and other early investors due to the tax-free transfer rules of section 1202.
