FINANCE

It’s Not What You Make, It’s What You Keep

Selling business interests, tax-free

Sara and Tom founded their biopharmaceutical company in 2014 as a C-Corporation and have grown the company substantially since launch. They’ve notched several successes along the way, all while reaching multiple fundraising milestones. Now they are planning for a liquidity event, from which they expect to receive over $100 million in sale proceeds, pretax. Assuming they land the deal, their estimated federal tax bill would come to $23.8 million. As with many successful founders and business owners, they approached a wealth planner to explore opportunities in advance of this event. Tom and Sara wanted to know whether they could reduce the income tax burden upon sale and shield their eventual heirs from an estate tax bill of 40%. We raised the possibility that their shares might be eligible for Qualified Small Business Stock (QSBS) treatment, also known as IRC Section 1202. The collaborative effort with their tax and wealth advisors netted millions of income tax savings, and additional estate tax savings for the entrepreneurial pair.

Can you benefit from this program?

Having successfully grown your company, would you like to be able to sell some of your shares potentially tax free? If you hold shares in a private company developing pharmaceuticals, medical devices or other products, you might be eligible. Most entrepreneurial founders and investors ultimately remit 23.8% of their long-term capital gain profits to the federal government, and many share an additional 3%–13% with their state government. But realizing long-term capital gains tax upon selling a business could be partially or completely sidestepped? It’s a benefit written into the tax code, designed to promote the development of small businesses. Investors, founders, or employees who receive stock in small businesses may be eligible for these significant tax savings, if certain requirements are met. IRC Section 1202, commonly referred to as Qualified Small Business Stock (or QSBS), outlines the requirements for a business to be able to exclude the greater of $10 million of gain, or 10 times cost basis, upon selling qualified small business stock. This means that shareholders can potentially avoid tax on up to $10 million of capital gain if the cost basis is less than $1 million—a figure that rises if the cost basis is greater than $1 million. For example, an owner with a cost

By Alliance Bernstein

KEY TAKEAWAYS: •Investors, founders, or employees who are shareholders in small businesses may be eligible for significant tax savings upon sale •But first, certain requirements must be met •Engage with qualified tax, legal, and financial professionals sooner rather than later to explore and maximize your opportunities

basis of $3 million could be eligible to exclude up to $30 million of gains from capital gains tax. Before you start sizing your savings, you’ll need to confirm eligibility. The rules are extensive and require advice from qualified professionals, though we share the highlights below. You can find a more detailed description in Qualifying for the QSBS Exclusion at www.bernstein.com. A quick summary is shown below, “QSBS Eligibility at a Glance.”

QSBS Eligibility at a Glance Corporate Structure Domestic C-corporations only Active Trade or Business • Any trade or business other than: • Service Businesses • Banking/Insurance/Leasing • Investment Management • Farming/Mining/Oil & Gas Extraction • Hotels/Motels/Restaurants

Gross Assets

Issuance Less than $50 million in gross assets between business formation and immediately after stock issuance • Stock must be issued when corporation is deemed a qualified small business • Stock must be issued directly from the company and received by a non-corporate taxpayer (e.g., individuals, pass-through entities, trusts)

SOURCE: ALLIANCE BERNSTEIN Making the grade

How might this play out in practice? Consider the following pass/fail scenarios.

Pass: Steve founded a small business that manufactures and distributes organic pet food. Steve formed his company as a C corporation and received his shares directly from the corporation in his revocable living trust. Steve’s shares meet the test for original issuance.

Pass: Andi invested $5 million in a fast-growing robotics company in exchange for preferred stock, bringing the gross assets of the business to $20 million. Two years later, the company’s gross assets have tripled to $60 million. Andi’s stock remains eligible for the QSBS exclusion because the company had less than $50 million of gross assets immediately after the issuance of her preferred stock.

Fail: Pavan founded an executive recruiting business that specializes in

placing candidates in the healthcare sector and formed his business as an S corporation. While his firm meets the “small business” test, it fails the “original issuance” test because shares were not issued from a domestic C corporation, nor would it qualify as an “active business” because it is a service business that principally relies on his expertise.

The devil is in the details

As these examples show, applying these tests to a specific company or stockholder’s stock is often more complex than it appears. The QSBS exclusion can be enormously valuable for founders, investors or employees with a stake in an emerging company. Such individuals would be well advised to understand this exclusion and the nuances of its requirements. These details may impact your decisions around initial business formation (or conversion of an existing entity), along with when to exercise options or time the sales of company stock. Keep in mind that the rules surrounding the QSBS exclusion are complex. Additional planning opportunities exist that may amplify QSBS to reduce taxes even further, while also minimizing future estate tax exposure. It is critical to partner with tax, legal and financial professionals who are familiar with these rules, who can help capture (and maximize) the opportunity. n

Alliance Bernstein authors: Daniel Brunello, Director—Bernstein Wealth Strategies Group Stephen Schilling, Director—Bernstein Private Wealth Management Pavan W. Auman, Director—Bernstein Wealth Strategies Group

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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfoliomanagement teams. Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions

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