Millions in tax-free profits? Here’s the loophole that survives Biden’s proposed tax hikes

Affluent Americans are panicking over the Biden administration’s proposed tax hikes, perhaps the steepest in a generation. But some investors on the cusp of potentially big-time wealth have far less reason to worry.

A loophole in the tax code known as qualified small business stock lets employees at small companies who receive stock as part of their compensation rake in $10 million — and often hefty multiples of that —free of federal tax. Known as QSBS, the perk has made employees at startups that exploded in value when they went public, like Uber, Pinterest and Slack, overnight millionaires.

Qualified small business stock is popular with Silicon Valley founders and employees, but others can potentially obtain it as well.
Qualified small business stock is popular with Silicon Valley founders and employees, but others can potentially obtain it as well.
Bloomberg News

The loophole won’t change under President Joe Biden’s sweeping proposals to increase ordinary rates and capital gains taxes. Evidence of that is buried in just 17 words on page 69 of the Treasury Department’s 114-page explanation of the proposals last May: “Finally, the exclusion under current law for capital gain on certain small business stock would also apply.”

“It’s one of the few tax breaks that seem to have avoided the chopping block in the Biden tax plan,” says Alexander Lee, a tax partner at law firm Cooley LLP in Los Angeles, California. “With the capital gains hikes and overall tax hikes, it is only going to become more powerful and desired as it will save incredible amounts of taxes.”

Fintech companies
Not just small tech company entrepreneurs and their employees are the winners in Biden’s tax plan. Businesspeople who start any company that makes something, and that’s not in financial services, law, accounting, real estate, hotels, restaurants, mining, oil and gas or farming, among other fields, can potentially set themselves up for the tax-free profits. Think wholesale, retail, manufacturing and technology, according to Northern Trust. And potentially fintech companies, according to an April “private letter ruling” — akin to a nonbinding seal of approval — from the IRS.

The safety net for the loophole is yet another benefit for financial advisors to consider for their clients.

In recent months, advisors have been scrambling to sort out their high net worth clients’ investment and retirement portfolios should Biden’s plan to nearly double the capital gains rate, now 23.8% with the Obamacare levy, become reality. Also scaring investors is Biden’s call for people making more than $1 million to pay ordinary rates on their long-term capital gains (on stocks and other assets held for more than a year). The top ordinary rate would rise to 39.6%, from the current 37%.

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The proposed tax increases are a major effort by the White House to raise taxes on the wealthy, a theme of Biden’s presidential campaign. Although the changes are being negotiated by Congress, most advisors expect higher rates next year for their clients.

But the proposed hikes won’t affect QSBS, which lets employees with stock in a company avoid capital gains tax on either $10 million in profits or 10 times their original investment, whichever is higher when they sell their stock. The second bucket can far exceed $10 million. 10 times fair market value on a company where the initial investment was $40 million can mean $400 million in tax-free gains for its shareholders.

Not well known by most advisors
Around since 1993, the tax break “is something that unfortunately is not well known in the entrepreneur and founder communities, and not broadly talked about in the accounting or advisor communities,” says Bill Loftus, a founding partner at Coastal Bridge Advisors in Westport, Connecticut. “The average advisor doesn’t know about it.”

For stock to qualify for the lesser-known loophole, a company’s gross assets have to be less than $50 million when shares are issued. (“Gross assets” refers to cash, property and intangible assets like goodwill; it’s not the same thing as a company’s valuation, which can be in the billions of dollars while it’s still low on assets). And it doesn’t matter if a startup’s assets later swell. As long as it’s under the $50 million limit, a company can issue multiple rounds of “original issue” stock that qualifies for the tax perk. By one scholarly estimate, the tax break saved investors more than $10 billion in capital gains taxes in 2019 alone.

Tricky rules
Lest entrepreneurs and early-stage company employees think it’s easy, there are key IRS rules to know.

The company must be a C corporation, not a partnership or other “pass-through” entity. It has to make something, which is why the perk is popular with Silicon Valley and tech start ups. “Service” firms like financial advisors, banks and brokerages aren’t eligible.

Employees have to hold on to their stock for at least five years before selling to get the gains tax free. Cooley's Lee says that an ordinary investor who doesn't perform services as an employee can still invest with property or cash and get the benefit.

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Also, “it’s difficult to obtain QSBS in the case of stock options” — a common form of equity compensation in some startups, Loftus says. “In the cases that we have dealt with, the founder always had common stock.”

The tax break was lucrative before Biden’s proposals. Now, it stands to become even more so. “If anything, QSBS will be more valuable if the tax law changes as proposed,” says Michael Shaff, an of-counsel lawyer at Stubbs, Alderton & Markiles in Sherman Oaks, California.

A few states don’t recognize the federal tax break. California, home to many tech startups, levies up to 13.3% on QSBS profits. Still, that’s one quarter of the top 56.7% that would hit investors with gains from the sale of other stock under Biden. Massachusetts levies 3%.

Say you’re granted $2 million worth of stock when your employer, a software maker started by Cornell undergraduates, is just starting out. Years later, the company gets bought or goes public, making your stock worth $30 million, and you cash out by selling the shares. You can take $20 million of that pot (10 times your original investment) to the bank tax free. Without the QSBS benefit, you would owe capital gains tax of nearly $2.4 million on that chunk — nearly double under Biden. (You do owe capital gains tax on the remaining $8 million — the excess $10 million minus your original $2 million — because it’s over the 10-times limit.)

Estate planning
Kevin Brady, an assistant vice president and CFP at Wealthspire Advisors in New York, where around five of the firm’s clients use the benefit, says that there’s “wider recognition amongst advisors at RIAs [registered independent advisors] than broker-dealer firms or wirehouses” of the perk. He cites a client who started a women’s casual clothing business several years ago, with a bricks-and-mortar store and online sales, who gets the benefit. “Once you put the scale of the numbers in front of people, and the numbers can really get crazy, they’re very surprised,” says Brady.

That’s because the tax break can be multiplied for heirs. Because the tax break for $10 million or 10 times the investment is per taxpayer, an employee who’s potentially heading toward the 1% wealthiest people can give some of her shares to children or put them in trusts. They each would get the same tax benefit. But gifts or sale of QSBS stock to a spouse get tricky, according to law firm Frost Brown Todd.

Fewer advisors still appear to know that owners of certain passthrough entities can either switch to a C corporation or elect to be treated as C corporation for tax purposes, potentially making them eligible for the benefit.

“I can't tell you how many S corps and LLCs I see where their advisors never told them about QSBS,” Cooley’s Lee says. “It is really hit or miss.”

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