The Section 1202 exclusion is one of the most valuable tax planning tools available to U.S. business owners and investors. It allows a non-corporate taxpayer (e.g., an individual or trust) to eliminate federal capital gains tax on the sale of ‘qualified small business stock’ (QSBS). Previously, this allowed for a maximum exclusion of $10 million or ten times the original investment, whichever is greater. The One Big Beautiful Bill Act (OBBB) increased the maximum exclusion to $15 million for QSBS acquired after July 4, 2025.
What is Qualified Small Business Stock (QSBS)
QSBS is stock of certain domestic C-Corporations. Foreign entities and other domestic entity types are not eligible. The corporation must actively engage in a qualified trade or business. Services businesses such as health, engineering, architecture, law, hotels, farming, banking and consulting are generally not eligible. The stock must also have been acquired at original issuance.
Prior to the OBBB, the stock must have been held for 5 years, and the aggregate gross assets of the corporation could not exceed $50M at the time of issuance.
OBBB expanded eligibility to corporations with $75M of aggregate gross assets at the time of issuance. The holding period was also shortened. Now benefits phase in starting at 3 years where 50% of the benefit is available and the full benefit is available at 5 years.
Maximizing the Exclusion
Some taxpayers may generate returns through the sale of QSBS higher than the $10 or $15 million allowable exclusion. In such cases, a potential strategy to increase the exclusion is known as “QSBS stacking,” where a shareholder gifts stock to other taxpayers, typically via non-grantor trusts, so that each eligible holder can claim their own QSBS exclusion.
Grantor vs. Non-Grantor Trusts
A grantor is the person who creates and funds a trust. The assets of a “grantor trust” are treated as owned by the grantor for income tax purposes. All income, deductions, and credits flow through to the grantor’s personal return, and the trust itself does not pay tax. By contrast, a “non-grantor trust” is considered a separate taxpayer and must file its own tax return. The assets held by the non-grantor trust are no longer treated as owned by the grantor for tax purposes. This distinction matters for QSBS because only non-grantor trusts can utilize the QSBS exclusion independently of the grantor.
Common Structures
There are two common types of trusts used to stack QSBS benefits:
- Completed Gift Non-Grantor Trusts: A completed gift non-grantor trust is an irrevocable trust in which the grantor transfers assets and gives up all control and beneficial interest, making the gift “complete” for gift tax purposes. Because the grantor no longer retains rights over the trust income or principal, the trust is treated as a separate taxpayer, meaning the trust pays its own taxes and the grantor does not report the trust’s income on their personal return. This allows the trust to claim a separate QSBS exclusion. The completed gift is a taxable gift and reduces the grantor’s lifetime estate and gift tax exclusion based on the value of the QSBS at the time of the gift.
- Incomplete Gift Non-Grantor Trusts (INGs): These trusts do not qualify as completed gifts for federal gift tax purposes but are structured to be non-grantor trusts for income tax purposes. This means they are separate taxpayers and could claim their own QSBS exclusion, but no taxable gift occurs when creating the ING. Thus, the grantor’s lifetime estate and gift tax exclusion is not used. However, they are not effective for California or New York residents.
Typically, the trusts are used for the benefit of close family members or others who would inherit the eventual estate of the original shareholder. In cases where a substantial gain is expected, separate trusts can be created for different beneficiaries to multiply the benefits further. Although, care must be taken to prevent the IRS from treating multiple trusts as a single trust for income tax purposes.
A Note on Voting Rights
When transferring QSBS into a trust, it’s important to consider who controls the voting rights of the stock. If the original owner (the grantor) retains the right to vote the shares, especially in a company they control, those shares could be pulled back into their estate for estate tax purposes. This also risks disqualifying the trust as a non-grantor trust, which would defeat the QSBS stacking strategy. To avoid this, the voting rights should be handled by the trustee or through a separate voting trust. It is critical to review the corporate documents to make sure they allow for this structure without causing unintended tax consequences or corporate governance issues. This is not an issue if the QSBS are non-voting shares.
Conclusion
QSBS stacking with trusts can be a smart way to increase the amount of gain excluded under Section 1202. It may also serve an estate tax planning benefit, when gifts are made while the stock price is low to remove the future appreciation out of the estate. Completed gift non-grantor trusts are the most straightforward method, but INGs may be useful in cases where the grantor does not want to trigger an immediate taxable gift.
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