Consider Section 1202 as Part of Your Estate and Trust Planning

Leveraging the tax benefits under Internal Revenue Code Section 1202 can complement wealth transfer and estate planning goals. This section allows certain taxpayers to exclude a portion, and in some cases all, of the gain from the sale or exchange of “qualified small business stock” (QSBS) held for over five years. Moreover, with the right strategy, recipients of QSBS as gifts can also enjoy these exclusions. 

Section 1202 QSBS Gain Exclusion: A Snapshot 

Originally introduced in 1993 to promote investments in small C corporations, Section 1202 initially provided a 50% gain exclusion from QSBS. This rate was elevated to 75% for QSBS acquired post-Feb. 17, 2009, and to a full 100% for those acquired after Sept. 27, 2010. 

For each taxable year, a taxpayer’s maximum gain exclusion from QSBS is the greater of: 

  • $10 million minus prior exclusions relating to the same corporation, or 
  • 10x the taxpayer’s adjusted basis in the sold QSBS. 

The $10 million limit can differ for married individuals. To be deemed QSBS, the stock should be acquired directly from the issuing C corporation. (1)

Section 1202 & Gifting QSBS 

An exception to the direct acquisition rule is that gifted QSBS retains its status. The receiver (donee) assumes the donor’s acquisition manner, tax basis and holding period. As every QSBS holder can benefit from Section 1202, gifting can optimize the overall gain exclusion on sales. 

While gifting QSBS can offer income tax relief, it’s not free from potential gift tax implications. In some situations, gift tax could overshadow the Section 1202 benefits. Always weigh the gift tax ramifications in your Section 1202 strategy. 

Gifting QSBS to Offspring 

Section 1202’s per taxpayer design means gifting QSBS to children might lower the total income taxes on its eventual sale. For instance, if a mother gifts part of her QSBS to two children, post a five-year holding period, each child could individually leverage the $10 million/10x basis exclusion limit, and so could the mother for her retained QSBS. 

Gifting QSBS to a Spouse 

The waters here are murkier. While each taxpayer holding QSBS should technically get their individual exclusion, for married individuals filing separately, the statute caps the exclusion at $5 million. Ambiguities remain about the exclusion limit for joint filings – is it per spouse or per couple? For clarity and to sidestep uncertainties, consulting tax experts is important.  

Gifting QSBS to Trusts 

Gifts to irrevocable trusts can serve dual purposes: protection from creditors and potential dodging of future gift/estate taxes. Be cautious, though. For Section 1202 benefits, the trust should be a non-grantor trust. If contemplating a switch from grantor to non-grantor status, be wary of potential tax implications. 

Death of QSBS Holder 

On the demise of a QSBS holder, the inheritors assume the decedent’s QSBS position. Given the mandatory tax basis adjustment to the fair market value upon death, the Section 1202 exclusion might be minimal if the stock is sold soon after at a marginal gain. Yet, holding onto it could reap Section 1202 benefits on any future stock appreciation. 

Gift Tax Implications of QSBS Gifts 

Always consider gift tax implications. The actual tax hinges on specifics like the donor’s gift tax exemption balance, QSBS value, and possible gift splitting with a spouse. Remember, the QSBS’s fair market value determines gift tax obligations, which can reach a rate of 40% on amounts exceeding available exemptions. Balancing potential gift tax with Section 1202 benefits is crucial. 

The current lifetime gift tax exemption sits at $12,920,000 (inflation-adjusted). It’s poised to halve come Jan. 1, 2026. Leveraging this higher exemption by gifting before the drop, including QSBS, could be a shrewd estate tax strategy. Always confer with tax advisors before making any decisions. 

Navigating the interplay between QSBS and estate planning requires a judicious approach. By understanding the nuances of Section 1202 and collaborating with tax professionals, one can strategically position assets for optimal wealth preservation and transfer. If you would like to discuss your estate plan, contact an Adams Brown advisor. 

(1) Source: Morgan Stanley, Inside the Qualified Small Business Stock (QSBS) Exclusion