Financial Planning Strategies to Enhance Qualified Small Business Stock (QSBS)

QSBS is arguably the most attractive tax strategy available to entrepreneurs and business owners in the U.S., and the current environment may be the golden age for QSBS strategies. There are several personal financial planning strategies that can enhance or even multiply the Section 1202 QSBS benefit, which allows for a capital gain exclusion of $10 million or 10 times the investment basis upon a liquidity event.

Before diving into planning strategies, it is important to note the key requirements for QSBS treatment. While this list is not exhaustive, here are some of the criteria to consider:

Prior to a liquidity event, entrepreneurs and business owners should carefully evaluate various strategies that may best suit their unique circumstances, both from a business and a personal perspective.

Conversions to C Corps
Owners of non-C Corp entities anticipating a large liquidity event may want to consider converting to a C Corp. Many business owners may prefer the pass-through deductions and flexible profit allocations of the LLC structure during the early years of a business. However, as the business builds momentum, a C Corp structure that is QSBS-eligible could be more attractive for a growing company that may be sold for a large capital gain.

For example, an LLC owner may convert to a C Corp, then start the clock on the 5-year holding period to garner the 10x basis or $10 million capital gain exclusion. Basis for QSBS utilizing a conversion is the fair market value of the shares at the time of conversion. This means that a wholly owned LLC valued at $8 million, with an actual cost basis of $1 million, would be eligible for a $73 million capital gain exclusion. This would be 10 times the $8 million value at conversion less the original built in capital gain ($7 million) at the point of conversion.

When it comes to entity conversions or the formation of entities upfront, shareholders should keep in mind that not every state recognizes a QSBS capital gain exemption. For example, New York state allows a capital gain exemption, but California and New Jersey do not. And while converting to a C corporation may be beneficial in some cases, doing so in a state with high local taxes on the C Corp may reduce the appeal of the QSBS benefit.

Founders should work closely with their advisors to model out the pros and cons of each structure, considering not only the eventual exit strategy, but also annual taxes, double taxation issues, and other considerations.

If a conversion is deemed beneficial, founders should be mindful to avoid conversions when the company market value is above the $50 million aggregate assets threshold after the conversion. Additionally, obtaining a defensible valuation report is recommended for documentation purposes.

Alternatively, founders could time the conversion as outside investors put additional capital into the business with the term sheet serving as the valuation substantiation. It is also worth noting that converting from an S Corp to a C Corp to garner QSBS status often involves a several step F reorganization structure.

Balancing Attractive Offers Against QSBS Benefits

For some fast-growing QSBS businesses that have not yet met the holding period for the $10 million gain exemption, an early and unexpected liquidity event can raise important questions to consider: Is it better to take the money now and pay a higher current capital gain rate, or hold out on the liquidity event until a favorable tax situation? Will the company be more or less valuable when the QSBS becomes eligible for the capital gain exemption? What will the merger and acquisition market look like in the future? Will tax laws be more or less favorable in the future? How challenging will it be to make the company more valuable between now and when you hit the 5-year holding period?

It’s also beneficial to run a breakeven analysis comparing the outcomes of selling now and reinvesting the proceeds versus waiting to sell after meeting the holding period. As an example, a company with a 3-year holding period could sell for $15 million today and net the same proceeds as a QSBS capital gain exemption sale two years later with a $12.2 million price. However, selling two years earlier would allow reinvestment of the proceeds for a longer period of time. Given that the real breakeven sale price, accounting for the reinvestment of the sale proceeds for two years at 8%, would only be $14.7 million.

It is important to note that buyers often prefer asset sales over stock sales for a variety of reasons (e.g. limits their liability, offers asset depreciation benefits, etc.). As a result of this preference, an asset sale could nullify the benefits of QSBS enhancement strategies. Different types of buyers have different types of structuring preferences and it’s important to keep those preferences in mind as founders ponder different strategies to enhance their QSBS benefit. Buyers may even use the QSBS exemption as a bargaining chip to garner a lower purchase price.

Strategically Exercising Stock Options

All QSBS holders are subject to a 5-year holding period requirement that starts when the taxpayer receives the original issue stock. It is for this reason, starting the clock on the holding period can be an important consideration.

To further complicate the process, when a founder, employee, or contractor receives stock option grants, whether it’s incentive stocks options (ISOs) or nonqualified stock options (NSOs), the holding period doesn’t begin until the options are actually exercised and the stock is received.

Holders often face a difficult decision balancing the potential QSBS benefits of early exercise versus the actual costs to exercising the options. Option holders would not only need to cover the cost of exercising their options, but may also face a substantial tax liability if the company's 409A valuation exceeds the option strike price.

For ISOs, one strategy is to run tax projections toward the end of the year and exercise only enough options to stay below the threshold that triggers the alternative minimum tax (AMT). As background, AMT is triggered when the fair market value of exercised shares exceeds the ISO strike price, so it then counts as income for AMT calculation purposes. If your AMT exceeds your standard tax calculation in a given year, you will pay additional taxes that year but receive an AMT credit as well. You get to use this credit in future years where your standard tax exceeds your AMT.

The option holder could repeat this process each year, executing only enough options to optimize their finances based on the combination of the amount of liquidity they have, minimization of AMT, and the probability and magnitude of an expected liquidity event.

That said, it is important to note that there is no definitive guidance on whether being issued a SAFE (Simple Agreement for Future Equity) starts the QSBS holding period.

One common mistake option holders make is not exercising options before the $50 million aggregate assets threshold is crossed. Option holders should be coordinating with the company CFO to understand and document the timing of when the company may cross this threshold.

Given the benefits of QSBS, option holders should carefully evaluate the advantages and disadvantages of exercising their options early to start the 5-year holding period as soon as possible.

Section 1045 Rollovers

IRC Section 1045 allows QSBS holders other planning opportunities to minimize their tax liability. For instance, if a shareholder has held QSBS stock for more than six months but has not yet met the 5-year holding period requirement at the time of a sale, they can reinvest the sale proceeds into another QSBS-eligible company through a Section 1045 rollover. By doing so, the shareholder can meet the 5-year QSBS requirement and benefit from the $10 million capital gain exemption upon the sale of the second company. One caveat here is that the rollover must occur within 60 days of the sale.

Founders can also use QSBS to rollover gains over the $10 million exemption into new shares to garner exemption on the excess capital gain. As well, if the rollover is into multiple companies, then the shareholder would receive a new $10 million exemption for each new company.

Given the tight timeline on the reinvestment, it can be problematic to time the sale of the first company and quickly identify and perform due diligence on the second company. One option could be to establish a new C Corporation into which the sale proceeds can be rolled as startup capital. However, this can also be challenging given the need to align the formation of a bona fide new venture with the timing of the liquidity event.

The attractive capital gain exclusion for QSBS can often be maintained when a company is purchased for new equity in the acquiring company. If a QSBS holder receives new non-QSBS shares from an acquisition after only a 3-year holding period, then the $10 million exemption is maintained within the new shares. That said, any subsequent growth in the new shares wouldn’t qualify for QSBS.

QSBS Stacking Strategy

A unique feature of QSBS is that the $10 million capital gain exemption is per tax payer. When a QSBS holder transfers some of their shares to another person or trust, the recipient becomes eligible for their own separate $10 million capital gain exemption. The recipient also inherits the original holder’s holding period.

As an example, if a shareholder is issued QSBS on 1/1/20 and three years later their child inherits the stock, they will inherit the original holding period as well. Further, if the inherited stock is sold three years later on 1/1/26, then they would be eligible for the $10 million capital gain exemption.

Combining the separate tax payer feature and holding period carryover features of QSBS can be lucrative. For instance, a QSBS holder may have $14 million in stock eligible for a $10 million capital gain exclusion. If that stock holder were to give 25% of their shares to a child (or a trust with the child as beneficiary), 25% to another child, and 25% to their parent, then each of the recipients would have $3.5 million of stock and a $10 million capital gain exemption. Collectively, they would have a capital gain exemption of $40 million if the company had a liquidity event.

Founders should work with their CPA, financial planner, and other advisors when implementing the stacking strategy to avoid running afoul of IRS rules on multiple trusts. Section 643(f) indicates that multiple trusts may be treated as a single trust if the grantor and beneficiaries are substantially the same and the primary purpose of establishing the trusts is deemed to be tax avoidance. In other words, setting up ten trusts to get $100 million of capital gains exclusion for three children isn’t likely to pass muster.

While trusts provide enhanced asset protection and greater control on distributions, founders should think through the pros and cons of direct gifting or QSBS stacking through trust structures. Trusts have additional ongoing costs, administrative requirements, and potentially higher compressed tax rates on the reinvestment.

Those considering the stacking strategy should keep the lifetime gift exemption in mind. While the exemption is set at $13.99 million in 2025, the 2017 Tax Cuts and Jobs Act is scheduled to expire in 2026, reducing the exemption to approximately $7 million. In an effort to lower future potential capital gains, an entrepreneur may find themselves in a situation where they end up paying current gift tax by exceeding the lifetime exemption.

The timing of gifts should also be carefully considered. In the case where the company is worth more over time, early gifts can use less of one’s lifetime gift exemption. Given the cost and administrative hassle of implementing trust gifts, many shareholders opt to make these gifts close to a sale. However, if a sale is too close to the timing of the gift, the IRS may argue the “assignment of income” doctrine and potentially disallow the gift.

Stacking strategies can be combined with other effective financial planning strategies to help minimize potential tax liability. The founder may want to consider gifting sharing to non-grantor trusts in tax-free states to avoid state taxes on the sale and/or reinvestment. Moreover, stacking gifts of minority interests can benefit from valuation discounts to minimize the use of the lifetime gift tax exemption.

QSBS Packing Strategy

Another strategy to potentially reduce future capital gains and increase one’s basis is to contribute cash or property in exchange for shares. The increase in basis would reflect the market value of the property or cash contributed on the date of contribution. Contributing $2 million of property would then allow a capital gain exemption of $20 million given the higher of 10X basis or $10 million rule. However, these new shares would be subject to a new holding period to satisfy the 5-year requirement, and shareholders should be mindful of the $50 million aggregate assets limitation post issuance of these shares.

Another way to effectively use the “packing” QSBS strategy is to sell both high and low basis tranches of stock in the same year. For example, a founder could sell $36 million worth of shares in two equally valued tranches. One tranche of $18 million was purchased for $10,000 and eligible for a $10 million capital gain exclusion. The second tranche was purchased by exercising stock options for $3 million. The basis for both tranches is $3,010,000, so the capital gain exclusion is $30,100,000. By utilizing this strategy, the capital gains would be $5,900,000.

Alternatively, if the shares were sold in different tax years, capital gains would be assessed on the first tranche in tax year 1 ($18,000,000 minus $10,000,000) and $0 for the second tranche.

That said, there are instances where selling shares across different tax years may result in greater after-tax proceeds than selling all the shares in a single year. If a founder holds multiple tranches of QSBS, they should evaluate the tax and financial implications of various selling strategies. These may include selling all shares in a single tax year, selling high-basis tranches first followed by low-basis tranches, or starting with low-basis tranches before selling high-basis ones.

Other Common QSBS Pitfalls

As founders and shareholders explore strategies to enhance or maximize the benefits of their QSBS, they should be aware of the following potential pitfalls:

Short positions aren’t allowed on QSBS stock, so post-IPO QSBS holders should generally avoid hedging strategies.
Heirs to a QSBS holder receive a step up in the cost basis of shares to market value at the time of death, which could render QSBS benefits irrelevant if the shareholder passes away before a liquidity event.
Documentation is key for QSBS. It is advised to carefully track the holding period for shares, thoroughly document purchases and additional contributions, and consider requesting certification of QSBS status from the company's CFO.
Account for QSBS on your taxes correctly - the sale of QSBS goes on Form 1040, Schedule D and the gain exclusion is reported on Form 8949.
Founders should be careful with any transfer of their shares, since there could be negative consequences in certain situations. For example, contributing QSBS into a partnership would disallow the exemption.
Founders should coordinate with their team to ensure that no business activities compromise the QSBS status. Having too many passive company investments, surplus working capital, or too much non-qualifying real estate can pose risks. Therefore, it is important to analyze the pros and cons, and alternative strategies carefully.

For example, it might make sense to lease instead of owning real estate in the business.

Proceed with caution in areas where the rules are unclear. Some would argue that strategies such as incomplete non-grantor trusts (ING) and charitable remainder trusts can bring added tax mitigation. However, it’s possible that there could be challenges at the state level or from the IRS on these structures.

As previously mentioned, we believe this the golden age for QSBS benefits. The current C Corporation tax rate, established by the 2017 Tax Cuts and Jobs Act (TCJA), stands at a historically low 21% and could potentially decrease further depending on future actions by the current administration. Furthermore, C Corporations may become more attractive compared to pass-through businesses, as the 20% qualified business income (QBI) deduction available to pass-through entities is set to expire at the end of 2025.

With the number of strategies available for QSBS, we believe founders and shareholders should carefully evaluate their options to potentially maximize this benefit.

David Flores Wilson, CFP®, CFA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.

Entrepreneurs, Most PopularDavid Flores Wilson, CFA, CFP®March 19, 2025NYC financial planning, NYC entrepreneurs, NYC financial advisor, QSBS, QSBS Stacking, QSBS Packing, QSBS financial planning, QSBS wealth management, QSBS NYC planning