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ACTEC Trust & Estate Talk
How the OBBBA Impacts Qualified Small Business Stock (QSBS)
00:14:42
ACTEC Fellow Kevin Matz
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How the OB3 act impacts qualified Small Business stock. That's the subject of today's ACTEC Trust and Estate Talk.
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Welcome to ACTEC Trust and Estate Talk from the American College of Trust and Estate Council, a professional society of peer elected trust and estate lawyers in the United States and around the globe. This series offers professionals best practice advice, insights and commentary on subjects that affect our profession and clients. And now our ACTEC Fellow host with today's topic.
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This is ACTEC Fellow Connie Ister of Boulder, Colorado. The One Big Beautiful Bill act introduced significant changes that affect the availability and scope of the code. Section 1202 exclusion potentially reshaping Qualified Small Business Stock Strategies for Founders, Investors and Estate Planning. ACTEC Fellow Justin Miller of San Francisco, California unpacks the key provisions impacting qsbs, offering expert insights on how to navigate the updated rules and make the most of this powerful tax saving opportunity under the new legislation. Welcome, Justin.
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All right, well, thank you, Connie. I'm going to promise you today three big changes to Section 1202 Qualified Small Business Stock under the recent One Big Beautiful Bill act, or which we'll call OB3 for short. But before I get into those three big changes, let me just give a quick overview of what is qualified small business stock. And really what we're looking at is section 1202. There's some key requirements. So as a brief overview, it has to be C Corporation stock issued after August 10, 1993. Now if you don't have a C Corporation, let's say you have an LLC taxed as a partnership or even an S Corporation, you may want to consider converting or doing a tax free reorganization to become a C Corporation, especially with these new rules. So we'll get to that in a little bit. But it's got to be C Corporation stock. The other requirement, 80% in general, 80% of the assets or at least 80% have to be used in an active what's called qualified trade or business. So what is a qualified trade or business? What the code tells us section 1202 is it just gives us a lot of examples of what is not a qualified trade or business. So there's a whole bunch of exclusions like health, law, accounting, performing arts, consulting, athletics, financial services, hotels, restaurants and others. So if it's that type of a business, you don't get QSBS treatment. So but everything else should qualify. The other big requirement before we get into the big changes is this rule called original issuance. And the original issuance rule says the shareholder must acquire the stock directly from the issuing corporation. What that means is you can't have QSBs that you purchased from another existing shareholder. You've got to get the QSBs directly from the company and either in exchange for money or other property, but not stock. You can get it as compensation for services you could exercise. Let's say options. You might get restricted stock as part of your compensation. And then there's another very special rule that says it is still qsbs if you get that QSPS via a gift or inheritance. So we're going to talk a little bit more about that at the end. But if it's qsbs from a shareholder, that shareholder can gift the stock or you can inherit that stock. It keeps the QSPS treatment. So now what are the three big changes under OB3? The first one, the first one is this gross asset limit. Notice that qualified small business stock has the two words small business in it. The old rule says that in order to be qualified small business stock, that company's gross assets could not exceed 50, $50 million through the time that stock position. So that is this called gross asset test. The old rule was $50 million. And by the way, that's not a fair market value test. It's cash plus adjusted basis of assets and it doesn't include self created intangibles like goodwill. So the company might be worth a lot more than 50 million. But we're looking at that gross asset test. So that was the old rule for new QSBs being issued. So after July 4, after the date of enactment of OB3 for new issued QSBs, we've got a new gross asset limit and it's $75 million. So it just expands the companies that these QSBS rules apply to. So even if you have an existing C Corp, and let's say, you know, on July 4th, its gross assets were 60 million, it wasn't able to issue any more new QSBs. But now that it's 75 million, that's an additional 15 million of QSBs that that company can now issue issue under the new $75 million limit. What that also means is that company, let's say it's, that's at 75 million. Let's say the company spends a lot of money on something like research and development. And next year it's back down to gross asset value of $60 million. Guess what, it can issue another 15 million depending on where that new gross asset test is. And here's the other nice thing, that 75 million, the new gross asset limit. It's adjusted for inflation after 2026. By the way, there's a slight error in OB3 where they referenced the wrong code subsection. It references section 1202B. It's supposed to be 1202 D, by the way, we all make dumb little mistakes in our lives and our careers. But at least for me, the one thing I can say is my mistake has never ended up in a published final tax legislation that was approved and reviewed by Congress and the President. But that's a minor detail. We'll probably get that corrected very, very soon. So that's the gross asset limit. Second big change is how much are you allowed to exclude? Let's say you've got this magical qualified small business stock. The old rule said that you were allowed to exclude 10 million. This is per taxpayer $10 million, the greater of $10 million or 10 times basis. Now, if you're an early employee in this company or you're a founder of this company, you probably don't have a lot of basis in in your company. So $10 million would have been your limit. The new rule, it increases that limit to $15 million per taxpayer. And that $15 million is adjusted for inflation after 2026. Now, this is only for stock issued after July 4, 2025. So after the OB3 legislation. Now it's not. Before anyone gets too excited, you don't get two limits. You don't get a 10 million and a $15 million limit. This is $1 figure limit. But it does mean if you're going to sell, you probably want to sell your $10 million QSBs, meaning the stuff you got before July 5th, you want to sell that first and then you get an extra $5 million of any QSBS that was acquired after July 4th. Now, do you get to exclude 100% of this, whether it's the greater of 10 million or 10 times basis or the greater of 15 million or 10 times basis. Well, that brings us to all these percentage limitations. And this is the third big change to qualified small business stock. As I said, I promised you three, the third big change. So what are these percentage limit limitations? So the original QSPS rule said you only could out of that 10 million or 10 times basis, you could only exclude 50% of the amount. And the 50% that wasn't excluded was subject to a 28% rate, which means your effective federal tax rate is 14%. But you also have that net investment income tax on top of it. And you have to worry about an alternative Minimum tax because the part that is not excluded from QSPS will be subject to AMT. So you've got that 50% limitation. Now that applies from the original QSPS rules. But during the Great Recession in 2009, the the percentage was increased first to 75% and then it was increased to 100%. So for stock issued after September 27th, 2010, you now are able to exclude 100% of your gains to the greater of 10 million or 10 times basis. If you get that before July 4th, 2025 and if it's after that date, the hundred percent of the greater of 10 million or ten times basis after that date. What that means is with this new $75 million rule, you could you and let's say a bunch of investors can go in and put in $74.9 million, let's say into a company that qualifies for QSBS, $74.9 million. That company, if it grows and expands over the years, guess what? You could exclude 10 times your basis, $749 million will be tax free. You exclude, you don't have to pay tax on your first 10 times basis, 74.9 times 10,749 million dollars excluded. Now the old rules that I just gave you, those percentage limitations, you had to hold the stock for five years. So the third big change is we get two new percentage limitations. What if you're selling this company and you haven't held the stock for five years, you want to exit, someone comes in, it's a great offer. So we get two new percentage rules that say, look, in order to qualify for usps, typically you have to hold it for five years. But for this new QR stock that we're issuing, we're going to give you this new rule. If you hold it for at least three years, we're going to still let you exclude 50% of your gains. Now once again, that means it's going to be subject to a 28% rate on the amount that's not excluded. You've got AMT potential AMT issues, you've got the net investment income tax, but at least you can still get the benefit of QPS without holding it for five years. Then there's another new rule on top of it that says, well, what if you hold it at least four years but you haven't held it for the required five years, we're going to give you another benefit. Instead of a 50% limitation at three years, we're going to give you a 75% limitation. So 75% of the greater of, let's say 15 million or 10 times basis, you still get to exclude even though you didn't have it for that minimum five year holding period period. Now, even though those two rules sound great, this new three year and four year holding period, there is a totally different code section that applies to section 1202 that allows you, if you don't meet that, whether it's three year or four year holding period, to hold it for an entire five. And it allows you to roll over your stock, your QSBs into new QSBs. That code section is 1045. So 1045, that code section gets, it gives you this special gain deferral that says, hey, if you don't meet the five year holding period, maybe you don't want a 50% or only 75% exclusion. You want the full 100%. Go ahead and roll over your QSBS into new QSBS and that way you will have the ability to make the full five year holding period. Now, for a lot of people, you don't want to roll over your QSBs into new QSBs because it's risky. What? Why would you want to risk it all? It's almost like going back to Las Vegas and putting all your money back on the table with why would you gamble it? Well, here's another part of Section 1045 that you can take into account and that is maybe you want to start your own new company. You can start your own new C corporation and roll over your gains. Now you better have a legitimate business plan and intention and all your books and records. You need substance and form. But if you do that in theory, maybe you can start your own QSBS company to roll over that qsbs and make the five year holding period. And then the last thing I just want to make sure I share is there's this concept of what we call stacking and that is say you have a founder who's got the. Let's say they qualify for the $15 million exclusion, this is post July 4, 2025 QSBS, but this company eventually could be sold for hundreds of millions of dollars, maybe even billions of dollars. Well, what that client can do is not only will they get a $15 million QSPS exclusion, but that they can set up non grantor trusts for let's say each of their children or loved ones. So let's just say they have four children and they set up four trusts. Each one of those non grantor trusts will get its own QSBS exclusion. So if we've got post July 4, 2025 QSBS instead of just one $15 million exclusion with four children, that's an additional $60 million in in exclusions. And if you're in a state like California that doesn't recognize QSPs, you don't get the federal QSBS exclusion at the California state level. Not Every state recognizes QSBs. You could set these non grantor trusts up in a state like Delaware or Nevada with good not only asset protection but no income taxes. And each one of those trusts could theoretically avoid or at least defer income taxes at the state level as well. So instead of a $15 million exclusion with four kids, now we're talking about a $75 million exclusion. We're also minimizing state income tax. And look, the cherry on top is those non grantor trusts can also be used for gift, estate and GST tax planning purposes. Meaning because you've made this gift, because you've set it aside, that stock not only could be sold tax free at least for the first greater of 15 million or 10 times basis or but also avoid future estate and generation skipping transfer taxes. So an additional 40% savings on top of the income tax savings. And with that, that's a quick summary of the changes under OB3 for qualified small business stock and I'll turn it.
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Back to you Connie thank you Justin for summarizing so effectively the changes to the QSBS rules. We really appreciate you helping us stay on of top of these changes.
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Thank you for listening to this episode of ACTECH Trust and Estate Talk, the podcast series about wealth planning matters from the American College of Trust and Estate Council. To find an ACTEC lawyer near you, visit actec.org Please subscribe to this series and leave us a rating or a review.