C Corp
Imagine a closely held and growing start-up business (“Corp”) that was recently incorporated under state law and, so, is treated as a regular C corporation for purposes of the federal income tax.[i]
Thus, Corp will pay income tax on its taxable income,[ii] and the losses generated in Corp’s first few years of operation – not uncommon with a start-up – will be trapped within Corp and cannot be passed out to Corp’s shareholders for their own use.[iii]
Double Tax?
In general, these shareholders – all of whom, it is assumed, are U.S. individuals – will be taxed on Corp’s after-tax income only when such income is distributed to them as a dividend, whether in cash or in kind.[iv] At that point, the corporation’s net after-tax income will have been taxed at a combined federal tax rate of almost 40 percent.[v]
However, it is unlikely that a growing start-up business, such as Corp’s, will have after-tax profits that are available for distribution. First, any available cash is probably being reinvested in the business. Second, the corporation may not have earnings and profits the distribution of which may be taxed as a dividend.[vi] Finally, Corp is likely subject to financial covenants imposed by its lender that prohibit dividend distributions while its debt remains outstanding. In other words, the risk of double taxation is relatively negligible.[vii]
Gift
Imagine that Corp’s sole or principal shareholder (“Shareholder” or “Grantor”) – who is not married[viii] – decides to gift a large portion of their Corp stock to one or more irrevocable trusts (the “Trust(s)” or “donee-Trust(s)”)[ix] organized by Shareholder for the benefit of Shareholder’s issue.[x]
Because Corp is a start-up, its fair market value is relatively low. Thus, Shareholder is able to make the gift in trust without incurring any federal gift tax or GST tax liability and without exhausting any significant part of their recently increased gift/estate tax exclusion or GST exemption amount;[xi] the thrifty use of these federal transfer tax benefits is an important consideration in the case of a start-up business, like Corp’s, which may ultimately fail, thereby wasting the exclusion/exemption amounts applied toward the gift of Corp stock.
Shifting Value
However, if Corp’s business does well, and the value of the corporation increases significantly beyond its date-of-gift value, Shareholder’s gift of Corp stock will likely have made a not insignificant dent in the value of Shareholder’s future taxable estate,[xii] while also benefiting their family.[xiii]
Gain Preserved
In general, the donee-Trust will take the gifted shares of Corp stock with the same adjusted basis the stock had in the hands of Shareholder.[xiv] The Trust’s holding period for the gifted stock will include the period for which the stock was held by Shareholder.[xv]
As is often the case with the owners of C corporations, Shareholder’s adjusted basis for their shares of Corp stock will not have changed much from their original basis for the stock.[xvi]
In fact, in the case of many successful C corporation businesses, a shareholder’s stock basis may be relatively small compared to the stock’s fair market value throughout much of such shareholder’s holding period for the stock.[xvii]
Income Tax Cost
Notwithstanding the economic benefit of reducing the future federal estate tax liability that will be owed by Shareholder’s estate and its beneficiaries, the donee-Trust realizes there is still a tax cost associated with the donor’s having successfully removed the shares of Corp stock[xviii] from Shareholder-grantor’s future gross estate.
Specifically, the donee-Trust (and ultimately its beneficiaries) may be taking the Corp stock subject to a potentially substantial future income tax liability that will be recognized on a subsequent sale, exchange, or other taxable disposition of the stock by the Trust.
The payment of the income tax liability resulting from this gain will reduce the economic value that Shareholder sought to bestow upon their beneficiaries by making the gift transfer to the Trust in the first place.
How may Shareholder preserve this value?[xix]
Grantor Trust
If the Trust was a wholly-owned grantor trust,[xx] the gain from the sale of the Corp stock would be taxed to Shareholder.[xxi] Not only would this preserve the value of the Trust, but it would also reduce the value of Shareholder’s remaining assets and future taxable estate.
In short, if income tax must be paid with respect to the gifted property, it is generally preferred that it be paid by Shareholder-grantor than by the Trust-donee.
What’s more, under current law[xxii] Shareholder’s payment of the tax owing from the sale of stock by the grantor trust would not constitute a taxable gift by the Grantor.[xxiii]
Unfortunately, there may be times that Shareholder may not have enough liquidity with which to pay the tax from the gain on the sale of the Corp stock[xxiv] and, so, may have to sell other assets,[xxv] or borrow funds, to satisfy the income tax liability resulting from the sale.
Alternatively, the trust’s governing instrument or applicable local law may give the Trust the discretion to reimburse Grantor for the latter’s income tax liability. The existence of that discretion, by itself (whether or not exercised) will not cause the value of the Trust’s shares of Corp stock to be includible in Grantor’s gross estate.[xxvi]
However, the transfer of liquid assets from the Trust to Grantor would reduce the economic benefit of the earlier gift to the Trust, much as it did in the case of a nongrantor trust that paid its own taxes.
Reacquire Trust Property
One way for Shareholder-grantor to turn the Trust’s grantor trust status to their advantage would be for the Grantor to reacquire the gifted stock from the Trust after it has appreciated in value, and prior to its sale by the Trust. The Grantor may transfer money or high basis property to the Trust in exchange for the stock. Provided the transaction represents an exchange of value for value,[xxvii] the acquisition will not be treated as a taxable sale or exchange, the Grantor will not be treated as having made an additional gift to the Trust, and the Grantor will not be treated as having received either a distribution from the Trust or a gift from the Trust beneficiaries.[xxviii] Assuming the reacquired, and now appreciated, stock is included in the Grantor’s gross estate, its basis will be adjusted to fair market value as of the Grantor’s date of death.[xxix]
Qualified Small Business Stock
What if, instead of focusing on the tax treatment of the Trust, as such, Shareholder-grantor instead funded the Trust with investment property the disposition of which would not necessarily generate taxable gain on which federal tax would be imposed?
Specifically, what if the shares of Corp stock gifted to the Trust were qualified small business sock (“QSBS”) within the meaning of section 1202 of the Code?[xxx]
Requirements
In general, section 1202 of the Code allows individual investors, and other noncorporate taxpayers, including trusts and estates,[xxxi] to exclude from their gross income up to 100 percent of the gain realized from the sale of QSBS, which is stock in a domestic C corporation with respect to which certain requirements are satisfied, among which are the following:
- The individual taxpayer acquired the stock directly from the issuing corporation (an original issuance);
- The taxpayer received the stock in exchange for money or other property (other than stock of a corporation) transferred to the corporation, or as compensation for services provided to the issuing corporation;[xxxii]
- At the time of issuance, the corporation must have been engaged in an active business, excluding certain businesses;[xxxiii]
- at least 80 percent (by value) of the assets of such corporation are used by the corporation in the active conduct of one or more qualified trades or businesses;
- not more than 10 percent of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations which are not subsidiaries of such corporation;
- not more than 10 percent of the total value of the corporation’s assets consists of real property which is not used in the active conduct of a qualified trade or business;
- During substantially all of the shareholder’s holding period[xxxiv] for such stock, the issuing corporation met the active business requirement and was a C corporation;
- At all times before the issuance of its stock to the taxpayer, and immediately after such issuance, the “aggregate gross assets” of the issuing corporation do not exceed $75 million;[xxxiv]
- this limitation is intended to ensure that the corporation is a “small business”
- “aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation;
- the adjusted basis of any property contributed to the corporation is determined as if the basis of such contributed property (immediately after such contribution[xxxvi]) were equal to its fair market value as of the time of such contribution.[xxxvii]
QSBS Holding Period, Basis
Where an individual taxpayer transfers property (other than money, and certainly not stock of another corporation) to a qualifying corporation in exchange for QSBS, then for purposes of applying section 1202 to the subsequent sale of any of such taxpayer-shareholder’s shares of QSBS, taxpayer’s holding period for such shares is treated as beginning on the date of the exchange, and in no event is the taxpayer-shareholder’s basis for the issued QSBS less than the fair market value of the property transferred to the corporation.[xxxviii]
This is consistent with the purpose of section 1202, which is to exclude from the taxpayer’s gross income only the gain realized after the original issuance of the QSBS by a qualifying corporation.[xxxix]
Per-Issuer Limitation
If a shareholder has gain for the taxable year from the sale of shares of QSBS of a single issuer corporation[xl] for which the shareholder has satisfied the requisite holding period,[xli] the shareholder may be able to exclude up to 100 percent[xlii] of such gain from their gross income for the year.
It’s clear that Congress added the generous exclusion rule of section 1202 to the Code to encourage and reward the kind of relatively longer-term[xliii] and substantial equity investment that an active start-up business needed to develop and succeed.
However, Congress must have also realized that, without certain limitations, potential investors may concentrate their capital in a limited number of start-up enterprises to the exclusion of other potentially worthy, but perhaps riskier, candidates that were also in need of capital.
I imagine Congress also recognized the potential for lost revenues without a commensurate, or offsetting, return on those “lost” (i.e., invested) tax dollars in terms of the number of successful start-up businesses attributable at least in part to the investment of those dollars.[xliv]
To address these concerns, the Code (i) allows an individual taxpayer to invest, and to claim the gain exclusion benefit from the sale of equity, in more than one qualified small business, and (ii) limits the aggregate amount of gain that may be recognized by a taxpayer on the sale of such taxpayer’s shares of QSBS in any one corporation.[xlv] Specifically,
(b)(1) If the taxpayer has eligible gain for the taxable year from 1 or more dispositions of stock issued by any corporation, the aggregate amount of such gain from dispositions of stock issued by such corporation which may be taken into account under [the gain exclusion rule] for the taxable year shall not exceed the greater of –
(A) the applicable dollar limit for the taxable year, or
(B)10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.
. . .
(4) . . . the applicable dollar limit for any taxable year with respect to eligible gain from 1 or more dispositions by a taxpayer of qualified business stock of a corporation is –
. . .
- B. if such stock was acquired by the taxpayer after the applicable date [July 4, 2025], $15,000,000, reduced by the sum of –
- the aggregate amount of eligible gain taken into account by the taxpayer under [the gain exclusion rule] for prior taxable years and attributable to dispositions of stock issued by such corporation and acquired by the taxpayer before, on, or after the applicable date, plus
- the aggregate amount of eligible gain taken into account by the taxpayer under [the gain exclusion rule] for the taxable year and attributable to dispositions of stock issued by such corporation and acquired by the taxpayer on or before the applicable date.
Thus, an individual taxpayer who sells shares of QSBS in two or more issuer corporations during a taxable year may exclude from the taxpayer’s gross income for such year the gain from the sale of each corporation’s stock subject to that corporation’s per-issuer limitation.
Stated differently, in the case of an individual taxpayer who sells shares of QSBS with a holding period of at least three years, the aggregate amount of gain (“eligible gain”)[xlvi] that may be taken into account by the selling shareholder in determining the amount of gain to be excluded from the shareholder’s gross income for the year of the sale (the “per-issuer limitation”) may not exceed the greater of (i) $15 million ($7.5 million for a married taxpayer filing separately), reduced by the aggregate amount of eligible gain taken into account by the taxpayer for prior taxable years and attributable to dispositions of stock issued by such corporation,[xlvii] or (ii) 10 times the selling shareholder’s adjusted basis for the shares of QSBS sold,[xlviii] determined without regard to any addition to basis after the date on which such stock was originally issued.
Exclusion from Gross Income
Having determined the per-issuer limitation, the selling shareholder must then apply the “applicable percentage” to such limitation to determine the amount of gain to be excluded. If the shareholder held the QSBS sold for at least 5 years, they may exclude from gross income an amount of gain equal to 100 percent of the per-issuer limitation for the year of the sale. If the QSBS is sold before then, the selling shareholder’s excludible gain is determined as follows: 75 percent of the per-issuer limitation may be excluded if the stock was held at least 4 years; 50 percent thereof may be excluded if the QSBS was held at least 3 years; and no gain is excluded if the stock was held fewer than 3 years.[xlix]
Bottom line: a single[l] individual who has held shares of QSBS issued by a single corporation for at least 5 years prior to the sale of any such stock may be able to exclude up to $15 million[li] of the gain realized from the taxable disposition of such stock, and a married[lii] individual, filing separately, may be able to exclude up to $7.5 million of such gain.[liii]
Significantly, Shareholder may reach the per-issuer limit by selling fewer than all of their shares of Corp QSBS. It depends upon how much Shareholder’s investment in Corp appreciated.[liv]
In light of the foregoing, how may Shareholder’s gift and estate planning be affected if Corp’s stock was QSBS which Shareholder acquired at original issuance after July 4, 2025, and then held for at least 3 years prior to the sale of such stock?
Gift Planning – Exclusion of Gain
The estate planning goals of an individual who owns shares of QSBS are generally the same as those of most owners of any closely held business – to transfer the economic value (including any appreciation) of such ownership interest to their family secure from creditors, and without incurring federal gift, estate, or GST taxes.[lv]
In general, the foregoing may be achieved by Shareholder’s making a completed gift of the Corp QSBS, with a fair market value not in excess of Shareholder-grantor’s remaining gift tax exclusion amount,[lvi] to a Trust for the benefit of their family.
But what about Shareholder’s ability to exclude from their gross income the gain from the taxable disposition of the Corp QSBS?[lvii]
As stated earlier, Shareholder is not married.[lviii] Will Shareholder’s potential future income tax benefit – i.e., the ability to exclude up to $15 million[lix] of the gain realized from the taxable disposition of the QSBS – carry over to the Trust and its beneficiaries?
Grantor Trust – All the QSBS
If the Trust to which Shareholder-grantor gifts all of their Corp QSBS is drafted as a grantor trust, Shareholder will continue to be treated as the owner of the gifted stock for purposes of the federal income tax.[lx] Thus, Shareholder’s basis and holding period for the QSBS – as determined for purposes of section 1202[lxi] – will not be affected by the gift of the stock to the Trust.
When the Trust later sells the QSBS, Shareholder-grantor, not the Trust, will be treated as having sold the Corp stock, the gain therefrom will belong to, and be reported by, Shareholder[lxii] as though the gift into the Trust had not occurred for purposes of the federal income tax. Thus, section 1202, including the per-issuer limitation for the year of the sale, shall be applied to Shareholder without regard to the gift.[lxiii]
Grantor Trust – Not All the QSBS
If Shareholder-grantor had retained ownership of some portion of their QSBS, which Shareholder sold as part of the same transaction in which the Trust had participated, the proceeds from the sale would be divided between Shareholder and the Trust based upon the number of shares sold by each. Their respective basis for the shares of QSBS held by each would be determined the same way – pro rata to the number of shares held by each.[lxiv]
For income tax purposes, the gain from Shareholder’s “direct” sale of stock would be added to the gain from Shareholder-grantor’s deemed sale via the Trust, and the total gain would be reported on Shareholder’s federal income tax return for the year of the sale.
Assuming Shareholder had at least a 5-year holding period for the Corp QSBS from the date of its original issuance to the date of its sale, and further that Shareholder had not previously sold any shares of Corp QSBS, Shareholder would be eligible to exclude up to $15 million of the gain realized from the sale regardless of how many, if any, shares of the Corp QSBS Shareholder gifted to the Trust, or how many of those gifted shares were sold by the Trust.
In other words, Shareholder-grantor’s ability – as the actual or deemed owner of the Corp QSBS for income tax purposes – to exclude from gross income the gain from the taxable disposition of such stock is not affected by the use of an irrevocable grantor Trust. Consequently, the federal transfer tax benefit of Shareholder’s gift of any number of shares of Corp QSBS to the Trust will not be reduced, because the Trust will not itself be required to pay income taxes or to reimburse Shareholder’s payment of such taxes attributable to the stock gifted to the Trust.
Nongrantor Trust – All of the Grantor’s QSBS
What if the Trust was, instead, a nongrantor trust, meaning that the Trust was recognized as a separate taxpayer from Shareholder-grantor, filed its own income tax return on which it reported its income, gain, etc., and was responsible for paying any tax imposed thereon?[lxv]
Assume Shareholder-grantor gifted all their shares of Corp QSBS to the nongrantor Trust. As stated earlier, the Trust would take the QSBS with the same basis the stock had in the hands of Shareholder,[lxvi] and it would add Shareholder’s holding period to its own holding period for the stock.[lxvii]
What about Shareholder’s ability to exclude the gain from the eventual taxable disposition of the QSBS? Does this “tax attribute” carry over to the transferee Trust?
According to the Code,[lxviii] a taxpayer who acquired shares of QSBS from a grantor as a gift is treated as having acquired such stock “in the same manner as the” grantor.[lxix] The transferee-taxpayer (the non-grantor Trust) is also treated as having held such stock during any continuous period immediately preceding the transfer during which the stock was held by the grantor.
In other words, the transferee-nongrantor Trust to which the shares of Corp QSBS were transferred – i.e., shares not acquired by the Trust at original issuance from Corp in exchange for property or services – will be treated as having acquired the gifted shares at original issuance in exchange for property or services, just like Shareholder-grantor.
In addition, the Trust would take the transferred QSBS with a basis equal to the sum of the amount of cash plus the fair market value of other property contributed by Shareholder-grantor to Corp in exchange for the stock.
Likewise, the Trust will be treated as having held the gifted QSBS for as long as Shareholder-grantor held such QSBS prior to the gift – Shareholder’s holding period will be counted toward the Trust’s 3-year, 4-year, and 5-year holding periods, and if Shareholder has already satisfied such holding period with respect to the stock by the time of the gift, the Trust will also be treated as having done so.
Thus, when the nongrantor Trust disposes of the gifted shares of Corp QSBS (in this example, constituting all such stock held by Shareholder prior to the gift) in a taxable transaction, the Trust will be able to exclude up to $15 million of the gain realized by the Trust on the taxable disposition; basically, the amount of gain Shareholder-grantor would have excluded on the sale if Shareholder had retained ownership of the QSBS.
Nongrantor Trust – Not All of Grantor’s QSBS
What if Shareholder-grantor transfers some, but not all, of their Corp QSBS to one or more nongrantor Trusts, say for the benefit of each child of Shareholder (of which there may be several) and such child’s issue?
There’s the rub.[lxx]
Stacking
Recall the Code’s treatment of gifted shares of QSBS: the “transferee” – the recipient of the gift, whether a trust or an individual – is treated as “having acquired such stock in the same manner as the transferor.”[lxxi] In addition, the transferee is treated as having held such stock during any continuous period immediately preceding the transfer during which it was held by the transferor.[lxxii]
One Interpretation
This may reasonably be interpreted as permitting the recipient of a gift of QSBS – who, unlike the grantor, did not acquire the stock at original issuance from the qualifying corporation in exchange for property or services – to step into the shoes of the grantor with respect to such transferred QSBS (i.e., to be treated as having acquired the gifted QSBS in the same manner as the grantor did), and to exclude from the recipient’s gross income up to 100 percent of the gain from their sale of such QSBS, subject to the per-issuer limitation.
As discussed earlier, the per-issuer limitation caps the amount of gain from the sale of QSBS issued by a specific corporation that a seller-taxpayer may exclude from their gross income for a taxable year. This “annual” cap is equal to the greater of:
$15 million,[lxxiii] reduced by the aggregate amount of eligible gain from the sale of QSBS of such corporation for prior taxable years that was taken into account by the taxpayer to determine the amount of gain from such prior sales that the taxpayer could exclude from gross income, or
10 times the taxpayer’s aggregate adjusted bases of the QSBS issued by such corporation and disposed of by the taxpayer during the taxable year.[lxxiv]
In determining the alternate per-issuer cap – 10 times the taxpayer’s adjusted basis for the QSBS – the recipient-Trust would start with that portion of Shareholder-grantor’s basis that carried over to the gifted shares of QSBS. Similarly, Shareholder-grantor would use the remaining portion of their stock basis in determining their own cap for a taxable year.
Under this interpretation, the grantor’s per-issuer limitation carries over, in a sense, to the transferee. In other words, the aggregate amount of gain that may be excluded by the grantor and the transferee from their respective sales of QSBS of a corporate issuer cannot exceed $15 million, regardless of how many shares either of them sells, and regardless of the number of years over which such sales occur.
As for determining how much of a grantor’s limitation carries over to the transferee, the more straightforward approach (and the one that is usually described in such discussions) is to divide the limitation on a pro rata basis, using the number of shares of QSBS gifted.[lxxv]
Another Interpretation
Contrary to the above interpretation, many seem to have concluded that the above-quoted phrase from section 1202 (regarding the transferee’s manner of acquisition) should not be interpreted as conveying only a portion of Shareholder-grantor’s potential tax benefit with respect to the gifted shares of Corp QSBS.[lxxvi]
According to this interpretation, if the grantor retains any shares of Corp QSBS, the grantor will also retain the ability to exclude from their gross income an amount of gain from the grantor’s later sale of such retained QSBS equal to the grantor’s remaining balance of their per-issuer limitation (say, $15 million).[lxxvii]
As for the gifted shares of Corp QSBS, in determining the “10 times basis” alternate per-issuer cap, the recipient-Trust presumably would still start with that portion of Shareholder-grantor’s stock basis that carried over to the gifted shares of QSBS – i.e. the Trust would not be treated as having actually made an investment in Corp that would justify its “own” independent basis.[lxxviii]
Under this interpretation, however, because the recipient-Trust is treated as “having acquired such stock in the same manner as the transferor” – directly from Corp (an original issuance) in exchange for an appropriate contribution – the Trust is treated as having independent statutory grounds for excluding up to $15 million of gain from the sale of the gifted QSBS, separate from the grantor’s own ability to do so.[lxxix]
For example, if Shareholder-grantor gifts one-half their shares of Corp QSBS to a nongrantor Trust, the Trust would take the shares with the same basis Shareholder-grantor had in the gifted shares, or one-half of the grantor’s total basis. The Trust would also add the grantor’s holding period to its own for purposes of determining whether the Trust had satisfied the requisite holding period(s) under the exclusion rule. Finally, under this interpretation, each of Shareholder-grantor and the recipient-Trust would be able to exclude up to $15 million of gain[lxxx] – $30 million in total – from their separate gross incomes following their respective sales of such QSBS.[lxxxi]
Based on the foregoing, if Shareholder-grantor had sold some of their shares of Corp QSBS and had excluded the gain realized therefrom, but less than the per-issuer limit, prior to gifting some of their remaining shares to the Trust, the Trust would nevertheless have the ability to exclude from its gross income up to $15 million of gain from its later sale of such gifted Corp QSBS.[lxxxii]
Stated differently, under this interpretation, the number of shares gifted by Shareholder-grantor has no bearing – unless some sort of de minimis rule is implied – to the section 1202 exclusion available to the transferee.
There does not appear to be any authority for this position, yet many have taken an expansive view of the statement, that a gift recipient of QSBS is treated as having acquired the stock in the same manner as the donor, to support the reading that the recipient of the gifted QSBS is treated as having contributed property to the issuing corporation, or as having rendered a service to the corporation, in exchange for its stock and for the potential to exclude the maximum permissible amount of gain under section 1202.
The fact the issuing corporation did not actually receive any additional capital or valuable service from the recipient of the gifted QSBS appears irrelevant to this interpretation, notwithstanding the legislative purpose underlying section 1202.
Does It Make Sense?
Consider the following: before becoming a shareholder, the individual grantor decides to establish a separate nongrantor trust for the benefit of each of their children and each child’s issue. The grantor makes a gift of property to each trust. The grantor and each trust ultimately invest money or other property in Corp in exchange for an original issuance of Corp QSBS. Assuming the holding period requirement is satisfied, no one would question the ability of any of these shareholders to take advantage of the full benefit of the section 1202 gain exclusion on a subsequent sale of their QSBS. After all, they did what Congress intended – each of them put capital at long-term risk in the start-up corporation in exchange for stock therein.
Under the second interpretation described above, however, that’s not what happened. Shareholder-grantor chose a different path, perhaps waiting to see whether the corporation’s business was likely to succeed before deciding to gift shares of Corp QSBS to the Trust, though the later gift may also have used more of the grantor’s gift exclusion than an earlier gift would have.
What if Shareholder-grantor was married and filed separately from their spouse? The grantor had the ability to exclude only up to $7.5 million of gain. Should the donee of a gift of QSBS from this grantor nevertheless enjoy the potential benefit of a $15 million exclusion? Query how this would encourage investment in a start-up business by an individual taxpayer.
What about the common law principle of nemo dat quod non habet – “no one can give what they do not have”? Although it is generally applied to one’s ability to transfer title to property or to grant rights with respect to property, should a variation of the principle have some bearing upon an individual taxpayer’s ability to multiply the finite tax benefit they received in exchange for acquiring shares of QSBS from a qualifying corporation?
It’s only a matter of time before Congress, the IRS, or the Courts address the issue.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Reg. Sec. 301.7701-2.
The business may have started its existence as a C corporation. (The default treatment for a state law corporation.) It may have been operated as a sole proprietorship (hopefully through a single member LLC that was disregarded for income tax purposes), or as a partnership prior to its conversion to a C Corporation. The “conversion” may have taken one of several forms: the assets of the business or its membership interests may have been contributed to a newly-formed corporation; the business may have merged into the newly-formed corporation; the business may have elected to be treated as a corporation for tax purposes while retaining its form of entity under state law; or the business may have used the state’s formless conversion statute, which is treated as a transfer of assets to a newly formed corporation. See Reg. Sec. 301.7701-3(c), (g); Rev. Rul. 2004-59; Rev. Rul. 84-111.
[ii] IRC Sec. 11. Flat rate of 21% after P.L. 115-97.
[iii] IRC Sec. 172. That said, to the extent the losses reduce Corp’s taxable income, there will be more after-tax income available to Corp to distribute to its shareholders or, more likely, to reinvest in the business.
[iv] IRC Sec. 301, 312, and 316. The distribution is treated as a dividend to the extent of the corporation’s accumulated or current earnings and profits. This may include a redemption of shareholder stock that is not treated as an exchange under IRC Sec. 302(d). If a dividend paid to a U.S. individual shareholder is treated as “qualified dividend income” under IRC Sec. 1(h)(11), it will be subject to federal tax at a top rate of 20%. It will also be subject to the 3.8% federal surtax on net investment income under IRC Sec. 1411.
Of course, an in kind distribution of appreciated property would be treated as a sale of the property by the corporation to its shareholders. IRC Sec. 311(b).
[v] The “double taxation” of a C Corporation’s profits. A combined federal tax rate of 39.8% [21% corporate, 20% shareholder dividend, 3.8% surtax on shareholder net investment income].
It bears noting, however, there are federal tax credits that may be especially beneficial for certain start-up businesses; for example, the R&D tax credit under IRC Sec. 41. (The business cannot claim both this credit and the deduction for R&D expenses under IRC Sec. 174A. IRC 280C coordinates these.)
Don’t forget to consider state and local taxes, as well as incentives. For example, New York imposes a 7.25% corporate tax on general corporations with a business income base over $5 million (otherwise, 6.5%); the state provides lower rates for qualified manufacturers (0%) and qualified emerging technology companies (4.875%).
NYC imposes a general corporation tax of 8.85%.
[vi] It may have net operating losses for several years. Although these will be carried forward, after P.L. 115-97 these NOLs may not offset more than 80% of the corporation’s taxable income for any taxable year. (This limitation became effective for taxable years beginning after Dec. 31, 2017, but was suspended during the “COVID years.”
[vii] That includes imposition of the accumulated earnings tax. IRC Sec. 531 et seq.
[viii] “I am an unmarried man, as opposed to a single man. A bachelor, according to the dictionary, is a man who has never been married. An unmarried man is not married at the moment.” Raymond Burr.
[ix] We begin by assuming the Trusts are nongrantor trusts; i.e., Shareholder is not treated as the owner of the Trust’s income and assets for tax purposes.
[x] Shareholder’s children and grandchildren. Shareholder will have to file IRS Form 709, U.S. Gift (and GST) Tax Return, for the year of the gift to report the transfer to the Trust.
[xi] IRC Sec. 2505 and Sec. 2010, as amended by OBBBA (P.L. 119-21). OBBBA also increased the GST tax exemption amount. IRC Sec. 2631. The unified estate and gift tax exclusion amount, and the GST tax exemption amount, are adjusted annually for inflation beginning after 2026.
https://www.taxslaw.com/2025/07/closely-held-businesses-and-their-owners-ask-whats-big-and-beautiful-in-the-recent-tax-law/
[xii] The removal of Corp stock from Shareholder’s future gross estate will also remove the appreciation in the value of such stock.
[xiii] By reducing the future estate tax liability, and by shifting ownership of the Corp stock and any appreciation in its value to the Trusts, generally beyond the reach of a beneficiary’s creditors.
[xiv] IRC Sec. 1015. However, if such basis is greater than the fair market value of the property at the time of the gift, and the done is someone other than the donee’s spouse, then for the purpose of determining loss the basis shall be such fair market value. IRC Sec. 1041(b)(2).
[xv] IRC Sec. 1223(2).
[xvi] Which may be the amount of money paid to Corp, or – in the case of a taxable exchange – the fair market value of other property transferred to Corp, in exchange for the stock, or, in the case of a tax-deferred exchange described in IRC Sec. 351, the adjusted basis of the property contributed to Corp. IRC Sec. 358.
Take a look at the 2024 Form 1120 (U.S. Corporation Income Tax Return), Sch. L, lines 22 (capital stock) and 23 (additional paid-in capital).
While Shareholder’s stock basis may not have changed, other investors may have contributed capital to the corporation’s business, often in exchange for preferred stock.
[xvii] Gifted shares are ‘encumbered” with this basis, whereas the basis of shares of stock acquired from a deceased shareholder (included in the decedent’s estate for tax purposes) will be adjusted to the fair market value of the stock as of the decedent’s date of death, which will often eliminate the gain inherent in such stock. IRC Sec. 1014.
[xviii] Along with the income to be produced by such property and its share of the appreciation in the corporation’s value.
[xix] A gift in trust that does not consider the income tax consequences arising from the gifted property may be full of surprises for both the grantor and the recipient.
[xx] Meaning the grantor-deemed owner is treated as “owning” all the income and capital gain attributable to the property. IRC Sec. 671. See Subpart E, Part I, of Subchapter J.
[xxi] The IRS has ruled that a grantor’s payment of the tax owing from the sale of property by a grantor trust does not constitute a taxable gift by the grantor. Rev. Rul. 2004-64.
Alternatively, the trust’s governing instrument or applicable local law may give the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability. The existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust’s assets to be includible in the grantor’s gross estate. Rev. Rul. 2004-64. However, the transfer of liquid assets from the trust to the grantor would reduce the economic benefit of the earlier gift to the trust.
If the grantor has the right to reacquire property from the trust by “substituting other property of equivalent value,” and exercises the right to reacquire the built-in gain property, then the grantor would receive the proceeds from the sale directly and, thus, would have sufficient liquidity to satisfy the resulting tax liability. IRC Sec. 675(4).
[xxii] The last Administration sought every year to address the inconsistency between the income tax and federal transfer tax treatment of grantor trusts. If I recall correctly, the Obama Administration may have done the same. If we’re honest with ourselves, their positions were not unfounded.
[xxiii] Rev. Rul. 2004-64.
[xxiv] For example, where Shareholder did not also sell shares of Corp stock with a value sufficient to satisfy their own and “Trust’s” income tax liabilities.
[xxv] Which may be taxable events unless Shareholder has assets with a built-in loss to dispose of.
[xxvi] Rev. Rul. 2004-64.
[xxvii] Rev. Rul. 2008-22.
[xxviii] IRC Sec. 675(4)(C).
[xxix] The last Administration proposed eliminating this swapping strategy – not a far-fetched proposal. It was eliminated by regulation for QPRTs almost 30 years ago. Reg. Sec. 25.2702-5(c)(9).
[xxx] IRC Sec. 1202(c).
[xxxi] The taxable income of which is generally computed in the same manner as that of an individual. IRC Sec. 641(b).
[xxxii] Presumably with the value of the stock being included in the service provider’s gross income. IRC Sec. 83(a). If the stock compensation was not immediately vested, the service provider may have elected under IRC Sec. 83(b) to include the value of the stock in their gross income (thereby cutting off the compensatory element), and to start running the 5-year holding period.
[xxxiii] IRC Sec. 1202(e)(3).
[xxxiv] Query what is meant by “substantially all.” For example, two years after the issuance of its stock, the corporation elects to be treated as an S corporation; after 3 years, the corporation admits an ineligible shareholder and loses its “S” election; it continues as a C corporation for 5 more years before its stock is sold. Does 7 out of 10 years satisfy the “substantially all of the shareholder’s holding period” requirement?
[xxxv] Adjusted for inflation after 2026. The cap is $50 million in the case of stock issued on or before July 4, 2025.
[xxxvi] Remember, the test is applied just before and just after the contribution in exchange for which the C corporation’s stock was issued to the contributor.
[xxxvii] IRC Sec. 1202(d)(2)(B).
[xxxviii] It is assumed for purposes of this post that Shareholder acquired all their shares of QSBS in one block, in exchange for cash, on a single day.
[xxxix] IRC Sec. 1202(i)(1)(A) and (B).
There is no tacking of holding periods. Compare the application of the holding period rules of IRC Sec. 1223 to an exchange of property in-kind for stock of the issuing corporation under IRC Sec. 351.
Any gain that was realized with respect to the appreciated property prior to its exchange for QSBS is not excluded under IRC Sec. 1202.
[xl] For purposes of this post, we’re assuming the individual taxpayer owns shares of QSBS of only one corporation.
[xli] Or should I say, one of the requisite holding periods, at least after OBBBA?
[xlii] Or 75% or 50%, depending on the holding period that was satisfied by the rime of the sale of the QSBS.
[xliii] Five years to enjoy any tax benefit before OBBBA; 5 years to attain the maximum tax benefit after OBBBA.
[xliv] The legislative history is not very informative.
[xlv] IRC Sec. 1202(b). This limitation is determined per-issuer. It is applied for as long as the taxpayer holds shares of QSBS issued by a particular issuer.
[xlvi] IRC Sec. 1202(b)(2). Assuming an acquisition after July 4, 2025.
[xlvii] We’re assuming the taxpayer did not acquire QSBS from the corporation on or prior to July 4, 2025.
[xlviii] Such basis being equal to the amount of money and the fair market value of other property contributed to the corporation in exchange for QSBS. IRC Sec. 1202(i).
[xlix] Though the gain may still be taxed as long-term capital gain.
[l] Unmarried.
[li] Adjusted for inflation after 2026. The amount excludible by the selling shareholder is capped at the greater of (i) $15 million ($7.5 million for a married taxpayer filing separately), or (ii) 10 times the shareholder’s adjusted basis for the stock sold.
It should be noted that if for any taxable year, the eligible gain attributable to dispositions of QSBS issued by a corporation and acquired by the taxpayer after July 4, 2025 exceeds the $15 million limit, then notwithstanding any increase resulting from an inflation adjustment for any subsequent taxable year, the dollar limit for such subsequent taxable year shall be zero. IRC Sec. 1202(b)(5)(B).
[lii] According to IRC Sec. 1202(b)(3)(C),marital status shall be determined under IRC Sec. 7703. In general, the determination of whether an individual is married is made as of the close of their taxable year, and an individual legally separated from their spouse under a decree of divorce or of separate maintenance is not considered as married.
[liii] In each case, assuming no prior taxable dispositions by the taxpayer of QSBS of the same issuing corporation. The exclusion amount is for taxable years beginning after July 4, 2025.
[liv] Remember, Shareholder’s basis for the QSBS does not change.
[lv] Sometimes referred to herein as the federal “transfer taxes.”
[lvi] IRC Sec.2505. Make sure you get a well-reasoned appraisal from a qualified and reputable appraiser. Make sure you adequately disclose the transfer on a gift tax return. See Reg. Sec. 301.6501(c)-1(f).
That said, consider a formula clause. See IRC Sec. 2001(f), Sec. 2504(c).
[lvii] We’re assuming there is no issue regarding an assignment of income by Shareholder. (I.e., as assignment of the right to the proceeds from the sale of the stock vs. an assignment of the stock itself.)
[lviii] The owner may be divorced. As of 2024, the U.S. divorce rate was somewhere between 40% and 50% for first marriages, and over 60% for second marriages.
[lix] As adjusted for inflation after 2026.
[lx] Rev. Rul. 85-13. The transfer to the trust is ignored for purposes of the income tax.
[lxi] IRC Sec. 1202(i).
[lxii] IRC Sec. 671; Reg. Sec. 1.671-3(a).
[lxiii] Of course, as a result of the completed gift for purpose of the gift tax, the proceeds from the sale will be paid to the trust – after all, the trust will it sold the gifted QSBS as a matter of state property law.
[lxiv] IRC Sec. 1015.
[lxv] IRC Sec. 641. See Part I of Subchapter J. We’re ignoring distribution deductions here.
[lxvi] IRC Sec. 1015, Sec. 1202(h)(1)(A), and Sec. 1202(i).
[lxvii] IRC Sec. 1223(2) and Sec. 1202(h)(1)(B).
[lxviii] IRC Sec. 1202(h).
[lxix] The grantor is the “transferor” in the provision quoted.
[lxx] Any fans of Hamlet?
[lxxi] IRC Sec. 1202(h)(1)(A).
[lxxii] IRC Sec. 1202(h)(1)(B).
[lxxiii] Adjusted for inflation after 2016.
[lxxiv] Assume for the moment that the grantor acquired the QSBS from Corp in exchange for $1.5 million of cash. Thus, its basis is $1.5 million, thereby rendering the “10 x basis” alternative exclusion amount inapplicable.
[lxxv] A second approach (which is rarely if ever mentioned) would determine which of the two taxpayers enjoys the benefit of the gain exclusion rule based on the timing of their respective sales of their QSBS relative to one another – if the grantor sells any of the retained shares of QSBS before the Trust sells any of the gifted shares, the per-issuer cap available to the Trust for its subsequent sale will be reduced or may be eliminated entirely, depending on the value of the stock on the date of the grantor’s earlier sale.
[lxxvi] It does not treat the gift recipient as stepping into the grantor’s shoes insofar as the per-issuer cap is concerned.
[lxxvii] Query whether this interpretation of IRC 1202(h) would be more defensible if Shareholder-grantor retains a more than de minimis percentage or number of shares of Corp QSBS.
[lxxviii] Basically multiplying Shareholder-donor’s stock basis. It’s not clear how this “inconsistency” is reconciled with permitting the transferee the potential benefit of a full $15 million gain exclusion.
[lxxix] For purposes of this post, we’ll ignore the potential for abuse that the use of multiple trusts for the same beneficiaries may present.
[lxxx] Ignore the post-2026 inflation adjustment.
[lxxxi] The retained shares in the case of the grantor, and the gifted shares in the case of the Trust.
[lxxxii] Of course, the per issuer limitation would continue to limit Shareholder’s ability to exclude gain from the subsequent sale of the Corp QSBS that Shareholder retained.
