Why QSBS matters for estate and tax planning

Qualified Small Business Stock (QSBS) under Section 1202 of the Internal Revenue Code can turn what would otherwise be a large capital gains tax bill into little or no federal tax for founders, early employees, and outside investors. That feature makes QSBS highly relevant to estate planning decisions: choosing whether to hold stock to satisfy the five‑year rule, whether to gift shares to family members, or whether to use trusts can materially change both income and estate tax outcomes.

(Authoritative references: IRS guidance on QSBS; see https://www.irs.gov/businesses/small-businesses-self-employed/qualified-small-business-stock.)

Key QSBS rules you must understand

  • Qualified issuer: Stock must be originally issued by a domestic C corporation. S corporations and partnerships do not qualify.
  • Gross asset test: The issuing corporation must have had aggregate gross assets of $50 million or less at all times from August 10, 1993 through immediately after the stock issuance (current statutory threshold) (IRC §1202).
  • Active business requirement: At least 80% of the corporation’s assets must be used in the active conduct of a qualified trade or business (certain service businesses and finance businesses are excluded) during substantially all of the taxpayer’s holding period.
  • Holding period: The stock must be held more than five years to be eligible for the Section 1202 exclusion.
  • Exclusion percentage and per‑issuer limit: For stock acquired after September 27, 2010, up to 100% of the gain may be excluded, subject to a per‑taxpayer limit equal to the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock (IRC §1202(a)).
  • Rollover option (Section 1045): Under certain conditions, a taxpayer who has held QSBS for more than six months may defer gain by acquiring replacement QSBS within 60 days of the sale (IRC §1045).

These rules are complex and highly fact dependent; taxpayers should keep contemporaneous corporate records to substantiate eligibility. (See IRS QSBS page.)

How QSBS interacts with estate planning goals

1) Death and the step‑up in basis

When a taxpayer dies, most assets receive a new income tax basis equal to their fair market value at death (a “step‑up”). For QSBS held until death, that step‑up often eliminates built‑in gain, removing any need to rely on Section 1202’s exclusion. That can be a favorable result if your objective is to transfer wealth tax‑efficiently to heirs.

Trade‑off: Selling during life to use the QSBS exclusion can free up liquidity for the owner but may consume part of the per‑taxpayer exclusion cap. Holding to death converts potential exclusion value into a step‑up, which is often more tax‑efficient for very large gains because it avoids using a limited per‑taxpayer QSBS cap. Example: If a founder has $25 million of unrealized gain in QSBS and the per‑taxpayer exclude cap is $10 million, holding to death may avoid tax on the remaining $15 million through basis step‑up, whereas selling during life could only shelter $10 million under Section 1202.

2) Gifting during life to multiply exclusions

Because the QSBS exclusion limit applies per taxpayer, transferring some shares (by gift or sale) to multiple family members can multiply the available exclusion. For example, if three family members each receive shares and meet the five‑year holding requirement, each can claim up to their own $10 million (or 10× basis) exclusion for that issuer — potentially sheltering up to $30 million of gain.

Caveats: Gifts may trigger gift tax reporting and use (or reduce) lifetime gift tax exemptions. Related‑party rules and anti‑abuse doctrines can limit advantages if transfers are artificial or if the transfers don’t satisfy holding‑period and substance requirements. Always coordinate gifting with a tax and estate attorney.

3) Trust strategies

Trusts can be effective owners of QSBS when structured correctly. Common approaches include:

  • Grantor trusts: Grants the grantor income inclusion while keeping asset control in the trust — holding periods may tack in some grantor trust situations, but trust drafting is critical.
  • Irrevocable family trusts: Can be used to divide ownership among beneficiaries to multiply the per‑person exclusions, subject to gift tax and state law.
  • Charitable remainder trusts (CRTs): Convert appreciated QSBS into an income stream and charitable remainder, potentially deferring or eliminating gain while providing philanthropic benefits.

Important: Trusts are taxed under different rules and some trusts may not qualify for step‑up at the grantor’s death in the same way as direct ownership. Also, state income tax treatment of QSBS varies and can negate federal benefits in some jurisdictions.

Practical planning scenarios with numbers

Scenario A — Sell during life using QSBS exclusion

  • Founder acquired QSBS after 9/27/2010 with $12M gain.
  • Per‑taxpayer limit covers $10M, so $2M remains taxable.
  • If exclusion applies at 100% for $10M and the remaining $2M is taxed at long‑term capital gains rates (plus possible NIIT), federal income tax liability is limited compared to full taxation.

Scenario B — Hold to death

  • Same founder holds the stock until death; heirs receive a step‑up basis equal to the FMV at death.
  • Capital gains tax may be effectively eliminated for the $12M gain without using the Section 1202 exclusion.

Which is better depends on liquidity needs, risk, state taxes, and estate tax exposure. If estate tax is a concern, transferring assets into trusts or using other estate‑tax techniques may still be necessary.

Due diligence and documentation checklist

  • Keep the original subscription agreements showing original issuance.
  • Save corporate balance sheets and financials proving the $50M gross asset test at issuance.
  • Retain board minutes, capitalization tables, and function/use statements to prove the active business test.
  • Track acquisition dates to verify the five‑year holding period.
  • Obtain a qualified tax opinion or legal memorandum where possible before relying on large exclusions.

Common pitfalls and state tax considerations

  • State tax differences: Not all states conform to Section 1202. Some states tax the gain that is excluded federally. Check state law where the taxpayer is domiciled.
  • Gift and related‑party traps: Gifting to family members to create multiple exclusions can trigger gift taxes and run afoul of anti‑abuse rules if not substantively backed by economic transfer and holding periods.
  • Loss of exclusion at death: A step‑up at death removes the benefit of a QSBS exclusion for heirs — sometimes desirable, sometimes not. Don’t assume both benefits apply simultaneously.
  • Documentation gaps: Without adequate corporate records, the exclusion can be challenged by the IRS.

Recommended action plan (practical steps)

  1. Early review: If you own or will receive founder stock, get QSBS eligibility assessed early (cap table, balance sheet, business activities).
  2. Coordinate advisors: Tax, corporate, and estate counsel must work together to align QSBS timing with estate goals.
  3. Consider staged transfers: Use gifting to family members or trusts when it makes sense to multiply exclusions, subject to gift tax planning.
  4. Preserve records: Maintain clear, dated corporate records and subscription documents.
  5. Evaluate hold‑to‑death versus sale timing: Model outcomes (federal and state) under both scenarios — sometimes a partial sale to use QSBS plus holding part of the position through death is optimal.

Interlinks and further reading

Final notes and professional disclaimer

QSBS is a uniquely powerful tool but highly technical. The choices you make—selling during life, gifting, or holding to death—have different income‑tax, gift‑tax, and estate‑tax consequences. In my practice, coordinated planning across tax, corporate, and estate attorneys early in a company’s life yields the best outcomes.

This article is educational and does not replace personalized tax or legal advice. Consult a qualified tax advisor and estate attorney before acting. (Authoritative source: IRS — Qualified Small Business Stock (Section 1202), https://www.irs.gov/businesses/small-businesses-self-employed/qualified-small-business-stock.)