QSBS: The Tax Strategy Business Owners Should Know Before Selling

Speaker 1 – 00:00
Sometimes people get obsessed, absolutely obsessed with not paying tax and either take risks that they shouldn’t
or they just do things from a business perspective that they shouldn’t.
Speaker 2 – 00:10
Your focus should be effectively creating a scenario where your effective tax rate on the proceeds that you’re
receiving is as low as it can possibly be.
Speaker 3 – 00:19
We’re going to do a deep dive on the tax code 1202 and otherwise known as QSBS and how you can shelter $15
million person up to five times that amount to 75 million DOL all tax free. If done correctly.
Speaker 2 – 00:33
This strategy, while it can be extremely valuable, can actually be a major deficit from a realization perspective upon
sale of your company if it doesn’t work out the way that you think it’s going to work out. What we see a lot of
people doing is we see gifting of original issued shares. But the tax savings should far outweigh the future
potential risk of you breaching the gift tax exemption.
Speaker 1 – 00:53
The burden of proof is always on the taxpayer. You might swear and say all this stuff, but you have to come
forward with evidence.
Speaker 2 – 01:00
Any strategy you take that has a tax mitigating factor in the eyes of the irs, you should be prepared to understand
what their original intention. If you have any inkling that you’re going to want to sell your business in the near future
and this could be something that you’re eligible for, then you should think about structure now and you should try
to employ or engage this strategy in a defined way from that point till when you actually sell it.
Speaker 1 – 01:21
You need good legal counsel because the buyer, they’re going to spend more time on the legal side doing diligence
and papering it to get you there’s.
Speaker 3 – 01:33
Today I’m joined by two industry experts in business transactions M and a tax both buy and sell side. And we’re
going to do a deep dive on the tax code 1202 and otherwise known as QSBS. And how if you’re a business owner,
you can shelter $15 million person up to five times that amount to $75 million all tax free if done correctly. So
whoever wants to lead us off, let’s give us give an overview of what QSPS is and the section 1202.
Speaker 2 – 02:07
So 1202 is an interesting strategy. It’s existed, you know, a long time. It was originally enacted in 93. It was a
regime set to reward small businesses that were situated as C corporations in the form of a tax shelter on
departure. Right. So that’s why it came about. It was a. It was A business motivated tax incentive for being situated
a certain way in the tax universe or structured a certain way in the tax universe. Now unlike or just like any other
tax provision, it comes with strings attached. So this QSBS concept has evolved over time and they layered in and
out different stipulations in order for you to qualify for that. But the long story short is that there’s depending on
when the organization of the business or the acquisition of the business itself occurred.
Speaker 2 – 03:01
C Corporation owner operators are entitled to, you know, from a 50% upwards to 100% shelter of your gain on
departure or sale of your shares as long as they qualify up to a certain amount. Right. That amount was $10
million per shareholder at one point. It’s now $15 million per shareholder to the extent that you’re eligible and
qualify and everything is structured and situated the right way. So in a nutshell, that’s what QSBS is. This is a
strategy that became a little bit more prevalent and popular in recent years because the roles, well let’s put it this
way, tax law has changed in such a way that it’s made C corporations more viable to exist in as an operating entity
as well as, you know, on the back end of it.
Speaker 2 – 03:46
They’ve kind of honed this call it shelter portion of the strategy to be more and more prevalent, to be more and
more able to be utilized across the board for either single owner enterprises or multi owner enterprises that are set
up for it.
Speaker 3 – 04:03
Okay, so we’ll do a deep dive here in a minute on all the nuances, technicalities. Let’s start with like a story that
you’ve seen a client that’s done this, had a successful transaction and like walk through the mechanics of it and
like real, you know, how it happened, give background on the, on you know, the business and then what was
actually saved in tax.
Speaker 1 – 04:24
One of the things Andy’s going to talk about is that this isn’t something that you wake up one morning, you just do.
You have to plan for it has to be thoughtful and you know, you really actually have to kind of model it out. And so
the situation that we see is there’s a rehab is there’s a entity is growing very fast and they have a mothership of
services and then they’re opening up offices at different areas, different cities across the country. They’re hiring in
talent and they want to incentivize them. So their headquarters entity is a pass through but the entities underneath
where they’re incentivizing people to come join are all C Corps that are with the intention of qualifying.
Speaker 3 – 05:10
What’s the parent entity structure?
Speaker 1 – 05:13
It’s a partnership. So they have all of the flexibility to do different things and have different arrangements between
the different ownership parties there. And then underneath it’s obviously a little bit more structured because C
Corp. So from an accounting perspective, it’s a little annoying because you have to do income tax accounting
which most accountants flee from and despise. So that adds some compliance and complexity there, the financial
statements. But you know, that really shouldn’t be the tail that wags a dog in any way but that, you know, what
they’re doing is they’re really maximizing like there could be an incredible tax shelter, you know, in an, in a
successful exit in the future. That’s obviously what they’re contemplating, you know, for all those various
shareholders and all those different entities.
Speaker 1 – 06:06
So they’re, you know, they may end up with, you know, 50 C Corps, you know, that are all separate with minority
owners within each one. So the extrapolating this benefit, you know, could be massive.
Speaker 3 – 06:22
So then buyer comes in and I don’t know, give some high level numbers on like what happened in this one, what
this, you know, range of sale price was.
Speaker 2 – 06:32
I’ll give you the buy side example.
Speaker 1 – 06:34
They haven’t exit.
Speaker 2 – 06:35
Yeah, they haven’t exited yet. But we have others that have. Right. On the tax group, we’ve advised them through
those transactions. But long story short, buyer comes in and the buyer has to be comfortable with the fact that
they have to acquire shares. Right. So that’s step one and that is a gating issue. If they’re looking to do an asset
deal, their strategy simply doesn’t work.
Speaker 3 – 06:55
Could they buy the parent company at the partnership level and get the benefits?
Speaker 2 – 07:00
No. So they would have to buy the shares. So the whole premise of this is it’s a qualified sale of small business
stock. Right. So the parent company being, in Tom’s case, a partnership can sell its shares of the underlying
organizations that are C Corporations and then the partnership itself is a shareholder and the residing partners
currently would be eligible for 1202 treatment. In most cases there are individuals that own C Corporations and
remember this used to be geared towards small businesses. Now that they’ve raised this caught asset
requirement to $75 million in gross assets, that this will now permit larger scale operations to actually get into the
arena and employ this strategy.
Speaker 2 – 07:47
And even more so now they, you know, the rules have been clarified and are further defined to allow businesses so
the determination as to Whether or not the shares qualify for this type of gain exclusion treatment upon sale is
evaluated at the date of the issuance of the shares or the acquisition of the shares, right? So if the business in
Tom’s ex business is well beyond the today the metrics that would permit it to be eligible for qsbs, but because
upon formation of the subsidiary C corporations that house certain elements of that operation, because they were
situated the way that they were whenever they were originally formed, they qualified at the outset and that stays
with you forever, right?
Speaker 2 – 08:30
So since the formation, as long as the shares are deemed what’s called original issue shares and eligible for this
QSBS treatment, you are then permitted then to carry that forward into perpetuity until you decide to sell your
business. The beauty of that one is that it fell under the newest tax regime. And the newest tax regime is the most
favorable tax regime from a sheltering of gain perspective and a flexibility perspective as far as how you divvy up
shares to be able to stack this benefit for eligible shareholders and how we can actually employ or entertain this
strategy on the true sell side when they’re actually ready. Now, Tom’s client is a great client because they did it with
eligibility in mind, right? So they had the proper forethought into getting into this arena.
Speaker 2 – 09:15
So everything is set up to be eligible for this QSPS treatment. On other deals that we’ve worked one in particular, I
can remember a small manufacturing company was a C corporation. They weren’t even sure if they were eligible
for this, nor did they even know what this was. Whenever they were talking about selling their company, right?
When we looked at it with them, we said, why aren’t we looking? Why aren’t we helping to facilitate this transaction
under this regime? And they said, well, how do we know? So that encompassed a lot of different moving parts, but
it was well worth their time at the end of the day. So this was a $15 million sale. It was a few years ago, but it was
under the 100% exclusion rule that existed before July 4, 2025.
Speaker 2 – 09:52
And what ended up happening was is they, after they discovered that this was an option, after we talked to them
and worked through the mental gymnastics of is this even a path for us? We immediately went back to the person
that was buying it who was proposing an asset deal, and we said, we really like to entertain a stock deal and here’s
why. And we transparently showed them the benefit to us from a tax perspective, right? We’re going to pay $15
million. They had no basis in the business or in the shares. Right. They found it, they founded it in their garage. So
there really wasn’t a substantial level of contribution that created this substantial built up basis that was going to
offset the gain. It was really up. The purchase price was almost entirely gain in this case.
Speaker 2 – 10:33
And so that being the case, the $15 million purchase price was able to be largely sheltered. Up to $10 million of it
was able to be sheltered through this QSBS treatment, but not without trials and tribulations of discovering
whether or not they were eligible. So they actually had to go out and get a study to make sure that their shares
were original issue shares and properly qualified that there wasn’t any secondary transactions riddled throughout
the history of the existence of this company that would disqualify any individual shareholder who is a shareholder
today from this type of treatment. And then secondarily it was before we get to an LOI stage right, let’s make sure
that we’re maximizing this. So we discovered that were eligible. We employed the strategy, we supplemented the
strategy and then we closed the transaction with them. Ultimately it was amazing.
Speaker 2 – 11:19
You know, they would have otherwise paid C corporations through an asset deal for a $15 million deal could pay
upwards of 45% in tax by the time you pay the for the underlying assets. Get taxed inside the C corporation and
then distribute what’s left after tax. Pay tax of 20% on that. It’s an exponentially high tax rate to pay just to sell your
company. And we’re going to talk more about this later. But that’s why this strategy, while it can be extremely
valuable, can actually be a major deficit from a realization perspective upon sale of your company if it doesn’t work
out the way that you think it’s going to work out. But this company in particular was looking at close to 45% in tax
due on a $15 million sale and ended up being zero.
Speaker 2 – 12:01
Or it was 23.07% on the sale of shares plus NIT. So another 3.8% on top of that on the sale of its shares but only on
$5 million of the gain as opposed to being on $10 million of the gain.
Speaker 3 – 12:20
Four or five million bucks easily.
Speaker 1 – 12:21
Yeah.
Speaker 3 – 12:22
So let’s before we get into the weeds, super high level example, imagine someone’s qualified for this. It’s now 26.
They’re gonna sing one person. One, one person owner C Corp. They’re gonna sell for a hundred million dollars.
Like what’s the, you know if. And we’ll get into like the stacking here. If what’s the best case scenario? Let’s say
they’re married, they can use this 15 million a couple times. They could use a trust like in this example. What’s the
best case scenario of tax that could be saved?
Speaker 2 – 12:52
So you can be as creative as you want. There is no limitation on the number of shareholders that can be eligible for
this. That being in case certain trusts, revocable trusts in particular, are harder to navigate in the QSPS world than
airref trusts. Right. But what we see a lot of people doing is we see gifting of original issue shares. First it goes to
the wife. If, you know, we all trust our family members. Right. But first it goes to the wife, then it can go to the trust.
But the trust beneficiaries can’t necessarily, you know, mirror each other.
Speaker 3 – 13:23
Does it be kids to say two.
Speaker 2 – 13:24
Different kids right there? It could be a, you know, kind of like a second to die type, you know, trust where it benefits
the wife but ultimately is intended to benefit the children. You can have separate trust for each of the kids instead
of having one trust that unilaterally, you know, will distribute assets in different proportions to each of the kids. But
you can supplement this in a lot of ways. And that was the supplemental piece of the example that I was giving
you before. So as long as it happens before the LOI is signed, because you can’t, deathbed planning just simply
does not work with respect to this strategy.
Speaker 2 – 13:56
But before the LOI comes into play, as long as you are transferring and or transitioning your shares into eligible
vehicles, which is going to be another individual, so it could be your wife, your kids directly, your cousins if you
want. Right. Anybody else, or key management for that matter, inside your business, they can all become eligible
just via a gift. Now, you got to be careful. The gift has to be documented, has to be at fair market value. The owner
is inevitably going to use part of its exemption to accomplish this. But the tax savings should far outweigh the
Meeting Title: 26 June EP 3 QSBS (For
Transcription).mp4
Meeting created at: 31st Aug, 2026 – 3:00 PM
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future potential risk of you breaching the gift tax exemption or your, you know, your lifetime gift exemption.
Speaker 3 – 14:37
So this example, let’s say one spouse ends, they get 15, other spouse gets 15. So that’s 30, that’s all tax free. Say
there’s two kids, they can each.
Speaker 2 – 14:48
Get individual shares or you can give it to trusts, or both. Right.
Speaker 3 – 14:52
So in this case there could be four, there could be a fifth. With the, with a trust could be kids, individual, and then
one trust, so.
Speaker 2 – 14:59
Be five, and then you can have a slat involved as well or a series of slats that can own portions of the business as
well. So you on a hundred million dollar sale you could get all of it. Right.
Speaker 3 – 15:10
Whereas if you didn’t do this, you’re going to pay, sell for a hundred and you’re probably going to pay 45 in tax net.
55. So it literally saves almost $50 million.
Speaker 2 – 15:20
And it’s done, it’s been done on a regular basis. The stacking element of this is not a new concept, albeit it’s been
clarified and highlighted over the course of time. There are anti abuse considerations associated with this. But this
is a legitimate defensible strategy that people have employed and you can absolutely do that. Where the unique
thing about this strategy is that it’s a shareholder by shareholder determination as long as you’re an eligible
shareholder. So US resident or US organization non corporate acting, you know, in a lot of ways as an individual.
Right. So even if it’s a trust, it’s really beneficial interest to an individual. You can supplement this or expand this to
cover a whole lot more gain than you may think. Right. So you’re not just limited to this $15 million figure.
Speaker 2 – 16:09
Each individual that participates in a qualifying way gets their $15 million copy.
Speaker 3 – 16:15
So let’s talk about, let’s first start who. I’ve seen this used a lot in tech companies. I know manufacturing is a big
one. Who qualifies. What are the industries specific that can do this?
Speaker 2 – 16:30
So the term of art and whether or not you qualify is that original issue shares. Right. And it’s a lot like it sounds.
Right. So if you form a company, it qualifies under the parameters of the asset level restrictions and things like that
then really it’s just making sure that your corporate documents stipulate that these are original issue shares. We
are releasing X number of shares to so many shareholders upon the formation of this enterprise. So Tom’s
example, that’s what happens every single time a subsidiary C Corporation enters the mix. Right. It’s documented
with an eye towards QSPS eligibility in mind. Right. The big hang ups on this are secondary purchases. Right. And
secondary issuances of shares.
Speaker 2 – 17:14
So not all the time, but a lot of the time, you know, secondary issuance of shares to broaden the owner pool of the
C Corporation will not be eligible. So those shares are just immediately, you know, cut out of the mix and those
shareholders are just out of the mix. Now if an owner takes part of his Interest and gifts it or sells it, there are ways
to structure that particularly gift is the easiest. Right. But selling it is another avenue in some cases where you can
buy original issue shares and you can be eligible as the buyer of those original issue shares for the qsbs treatment.
But again, not without proper documentation, proper consideration along the way. So long story short, the eligibility
surrounds you meeting the criteria of the original issue shares portion of this.
Speaker 2 – 18:00
If that, if that gate can’t be overcome or if you can’t get beyond that, then none of this strategy is going to follow
through. And there are companies out there for elder companies that want to qualify for this, they’ll actually go out
and they’ll do a legal share study to make sure that they are all definitively eligible for this QSBS treatment under
the terms of the original issue share requirement. So it’s not hard. But for absent consideration of this upfront,
going back and trying to recreate, you know, that trail of, you know, how did these shares originate and who was
the, you know, how have they transferred over time and how many issuances have happened. Like it dumb it, I’m
dumbfounded now we’re younger, right. But I’m dumbfounded at how many people you ask that question to and
they’re like, I have no idea.
Speaker 2 – 18:47
Right. Especially 60, 70 year old family owned organizations, they just, they never pay. They don’t even know where
their shares are at. Right. But they were printed once, they sat in a safe once. They just don’t know where any of
that legal paperwork even lives anymore.
Speaker 1 – 19:01
And the burden of proof is always on the taxpayer. So you know, you might swear and say all this stuff and yeah,
was that. But you have to come forward with evidence otherwise you’re just not going to get it.
Speaker 3 – 19:14
Okay. So original issue and issued shares is first criteria and then the asset range of the business is 75 million.
Speaker 2 – 19:24
Plum formation. Yeah. So your business can’t be what they’re trying to preclude is somebody. So everybody taking
their businesses that are worth $100 million, right. And saying, you know what we’re going to do, we’re going to
contribute this to a C corporation that we formed today and then we’re going to sell it in a year and then we’re
going to get this exclusion treatment in there. So the reason that this stipulation exists is this is intended to benefit
small businesses that may or may not be on the verge of sale. And that was further highlighted with this newest
OB3, you know, the newest OB3 provisions that came out Right. Those provisions specifically stipulate that there
are holding period beneficial situations based on holding period. Now, that didn’t necessarily exist before. So that’s
where that three, four and five year tier comes in.
Speaker 2 – 20:11
That didn’t exist before. But it just further highlights what the original intention of the IRS was, which any strategy
you take that has a tax mitigating factor in the eyes of the irs, you should be prepared to understand what their
original intention when they enacted this provision was or this strategy was because they had it, you know, they
situated it the way that they did for a reason and then how we currently qualify for it. Right. So when Tom tells you
the burden of proof is on the taxpayer, that’s 100% true. In the event that it’s an older organization and we don’t
have the ability to go back and document how it became eligible for this QSBS treatment, it probably behooves
them to pay these specialty consultants to go back and trace that legally for them.
Speaker 2 – 20:52
In the event that we’re a part of it at the outset, it’s really easy because that documentation exists in our files at the
date of the origination of the organization and that’s always there. And top of mind, in the event that we get to a
sales scenario,.
Speaker 3 – 21:06
I know there was a, there’s a five year window, you’re saying now there’s a three year window. What’s the. You can’t
just convert to C Corp and sell the next day. Right?
Speaker 2 – 21:13
Yeah. So under the newest legislation that’s out, which was on July 4, 2025. That came out. Right. What they did is
they shifted from a mandatory hold period which used to be, I think, three or five years before you could even be
eligible. So you, before you couldn’t just create and sell as well. Right. There was always a holding period, but with
the newest legislation did is they created what we call more favorable outcome for taxpayers and that if you have
enough foresight, you only really have to hold this thing for three years in order to be eligible for some level of
benefit. Right. So that three year number is 50% exclusion.
Speaker 2 – 21:49
The four year number is 75% exclusion and five years 100% exclusion up to the limit, which is now $15 million
instead of 10, which under my previous example, the individual owner was eligible for that 10% clip or that $10
million clip as opposed to the $15 million clip. So. So that’s the newest regime. Now this is subject to change,
albeit I don’t think we’re going to be seeing tax law change. Here in the next two or three years and then depending
on what happens after that, it very well could be something different than this. But this is widely regarded now as a
tax shelter. So politics aside, it is envisioned or it is viewed publicly as an ability for wealthy people to, you know,
call it capitalize on loopholes inside the tax law.
Speaker 2 – 22:38
Not a loophole, but it certainly is a strategy that if you employ it well, it really does benefit you. So the newest
regime is the best regime and it does give you that option that you can form and after three years you can still be
eligible for a benefit, whereas you couldn’t necessarily do that under the previously existing tax regime.
Speaker 1 – 22:56
One thing on that timeframe, if you have a safe vehicle or if you have stock options, you have to pay attention. It’s
not when you get them for a safe, it’s when you exercise or you convert it. Same with stock options. If you get
granted them, that doesn’t start the clock. It has to be upon.
Speaker 3 – 23:18
So the origination of the C Corp assets has to be under 75 million. So if a business is at 100 million of assets, they
can’t just flip to it. So either day one, when you form the entity, do it, or if you’re under that and you’re thinking of a
transaction now and you’re in your example you just gave, what if they get issued stock options below the 75
million number but then when they go to exercise it, they’re over? Does that disqualify it?
Speaker 2 – 23:46
So it’s a baseline, the issue date of the shares themselves. Right. As opposed to, so let’s call it triggering event
occurs your options based shares that you are to receive. Right. They could qualify or not qualify depending on the
size of the company at that time of issuance or of exercise of issuance. Right. But the holding period that Tom’s
talking about is this three, four or five. Right. So the differentiating factor is those shares were technically issued.
They could have been in a reserve pool, an options pool forever. Right. But they’re still original issue shares, so that
doesn’t necessarily disqualify them. So it’s not a supplemental issuance, it’s not a new issuance. As long as those
shares were available to issue to somebody at the date that the company was formed and was eligible for this
QSPS treatment, then you’re okay. Right.
Speaker 2 – 24:39
If it’s a new issuance at the date that these stocks are awarded, I. E. They’re just going to issue more shares to you
as a result of this option that you have, the buy in, which happens sometimes, then that could not be eligible. It’s
likely not going to be eligible for this QSPS treatment.
Speaker 3 – 24:54
Okay, so let’s. Can you either give an example of company that’s came, that has come to you, they’re a partnership
or an S corp. And what’s the process like to then, you know, they come to you, they say, you analyze it, we’re under
the 75 million number, we want to sell in three to five years. What’s the process like to flip to a C corp?
Speaker 2 – 25:16
So that’s an interesting question because it depends on how they’re situated now. So the end result is the same,
right? It’s going to ultimately be a multi owner C corp, right? That’s fine. The question is how do you get your
existing business into that? So effectively there are ways to just simply convert a business. If it’s an llc, it can elect
to be treated as a C corporation. Right? That’s a little hairier, but we can talk about how that could work. There’s S
corporations that have significant restrictions on how to restructure it. Right now, going from an S to a C
corporation doesn’t cost you any money. It’s going from a C to an S corporation, it actually costs you money. But
long story short, there are ways to do that as well.
Speaker 2 – 25:55
But the cleanest, most simple way to do this will be to form a new C corporation, contribute and contribute your
assets into there. So there’s either a 721 contribution or there’s a 350, I think, merger type, you know, consideration
on the corporate side that you can utilize in order to get your assets into a qualifying C corporation without
disrupting, you know, a zillion things, but also preserving that original issue share concept, right, that existed. So if
you form it today and you contribute your assets, and your assets can include your interest in an llc, an S
corporation, any of those things to that C corporation, you’re automatically eligible. I think what people tried to do
in the past, and we’ve seen people talk about it a lot, is it, you know, I’ve had this s Corporation for 20 years, right?
Speaker 2 – 26:41
It was a, you know, in some cases it was a more favorable exclusion. If we would have went back to the original
formation date of the company, which was an LLC taxed as an S corporation, then it would have been, you know,
under the 50% regime that existed shortly thereafter, or they qualified or didn’t qualify, period, full stop. Right? So
long story short, if you look at it logically, the easiest way to do it, albeit, puts a, you know, timeframe on it. You
know, you have to be there for three years or you have to have it for three years to accomplish it. But long story
short, if you contribute or you merge and the surviving entity and the operating entity becomes the newly formed C
corporation, you’re in pretty good shape. You can be pretty confident you’re going to continually qualify.
Speaker 3 – 27:25
Can you give a high level overview of the 721? So you essentially my understanding, and you’re obviously the
expert, you take the asset, contribute it, and then the basis transfers over into the new.
Speaker 2 – 27:37
So 721 is a mechanism in the tax code that permits you to contribute assets at carryover basis, just like you said,
to a qualifying organization. So that could be a C corporation, s Corporation, another LLC or partnership, any of
those things. But what 721’s benefits are is that you essentially are able to contribute without having to
acknowledge that they’re is potentially unrealized appreciation and what you’re contributing to that new
organization. So we had deal down in Texas, we had a group of individuals, one had a construction company, the
other one had an equipment reseller and rental company, right? So those two things went together very well. They
were equal in size. They said we don’t want to do a joint venture, we want everything to be under one house. Right.
How do we do that without paying tax?
Speaker 2 – 28:25
Well, they were both S corporations, right? So there’s no distribution of assets from an S corporation because that
creates tax on the fair market value versus the basis of those assets upon departure. So instead we employed a
contribution strategy where both sides contributed their businesses to a new business that they formed, which
they chose an LLC for that because they wanted flexibility. But they were able to through 721contribute into that
newly situated holding company. And the core basis there is that you’re contributing it and receiving proportionate
value back, right? So if the combined enterprise of the IRS ever wanted to look at it and try to negate and say
somebody benefited and somebody didn’t, what they would do is say, is it really disproportionate in value as far as
what people contributed versus what they ended up with?
Speaker 2 – 29:13
At the end of the day, that’s a balance and moderation question, right? So. Or you know, if you want to use the
corner term, pigs get fed, hogs get slaughtered. If you’re just reasonable about it’s hard to refute, right? And you
say, okay, I’ve got the construction company, I’VE got the rental company together, they make sense and they are
proportionately equal either from an asset value perspective or from an operating cash flow perspective. You can
always make the argument justifiably work.
Speaker 3 – 29:39
So if you’re going into a new C Corp to qualify for qsbs, can you do partnership? S corp doesn’t matter.
Speaker 2 – 29:46
Yeah, I mean there are obviously limitations on how things flow up, but C corporations can generally own
everything but an S corporation. Right. So C corporations are not eligible owners of s corporations, but LLCs,
partnerships, anything like that, more flexible vehicles or other C corporations. That’s all possible. So you can get
yourself into a C corporation without a significant issue. In this case, in the case for our Texas folks that did it,
right. The S corporation contributed all of its operations downstream into an llc. That LLC then was contributed
into the C corporation or in this case the LLC that they formed. And that’s how we had to do it. So mechanically you
just have to trace it, you know, you have to put the value into an eligible vehicle that can be tax free contributed via
721into a new enterprise.
Speaker 2 – 30:43
Every situation is a little bit different. And most of the times when there’s hang ups on this contribution type regime
is whenever there’s assignment clauses from a contractual, like a contractual perspective or things like that.
Because like I said, not that I’m saying that valuations are voodoo, but you can usually make valuations match
based on perceived risks and some level of manipulation within reason. Right. To show that they’re proportionately
equal or the percentages make sense post contribution. So that part’s a little bit easier to navigate. The harder part
to navigate is eligibility. Is my business even technically allowed to do this? Can a C corporation have my S
corporation? No. Can I do it? Sure. It was just an extra step.
Speaker 3 – 31:24
Have either of you seen any hang ups from a buyer coming in? Because it’s more advantageous for a buyer to buy
an asset versus stocks to get to the depreciation. Has there been any limitations on taking a. Trying to qualify for
qsbs going to market? If any buyers had any hang ups.
Speaker 1 – 31:44
With this, I mean, the buyers, generally speaking, don’t want to buy legal entities because of liability. So when you
buy stock, you know, you buy equity, you’re buying all the.
Speaker 3 – 31:57
They want a new entity, right?
They want a clean slate from liability. So if there’s a litigation that comes out of the closet, it’s all the old entity. So,
you know, like Andy said at the beginning in that example, you have to go to the buyer not with hat in hand but you
have to be ready to compromise on things. They’re absolutely going to want indemnified and there’s going to be,
you know, really significant carve outs on indemnification and then liabilities that they’re not assuming, you know,
as part of that transaction. So you can do it, you know, but you need good legal counsel, you know, because the
buyer is, you know, they’re going to spend more time on the legal side doing diligence and papering it to get you
there. So that’s generally speaking that’s a buyer’s resistance to a stock deal.
Speaker 1 – 32:53
There’s other reasons they might want a stock deal because you don’t have to transfer contracts or vehicle titles or
things like that. So sometimes that works out but sometimes, particularly industries where there’s environmental
concerns and things like that, they just will not touch equity. So you know, at all these things that are being talked
about all point to. You really need to have someone that knows this up front because you can’t wing it. You know,
you don’t want to go to chat GPT and say how do I do QSBs? You know, you might start there but then you need
somebody that’s been through yeah and they can help you qualify.
Speaker 3 – 33:38
What’s the biggest like horror story? Where have you seen this go to the worst? Somebody either come to you and
it’s already messed up or like what’s the worst outcome if this is not done correctly?
Speaker 1 – 33:50
I haven’t seen anything horrible. It’s what I see is just people hearing about it and it’s too late. They’re already an S
corp and to switch, they can’t do it for some reason.
Speaker 2 – 34:03
I’d say the biggest horror story that can come out of this, not necessarily that has, is that you become infatuated
with this tax strategy and then the tax tail becomes, you know, the, it starts to wag the business dog, right? So
you’re wholly invested in this QSPS program that exists and the tax benefits that are associated with it. And then
you go to sell your company and you realize that buyers simply aren’t going to offer you the right amount of money
for the shares because of the perceived risk of the, you know, unknown liabilities and anything else that gets there.
Then you’re stuck in a C corporation, right. You’re going to sell, you’re going to pay an enhanced tax rate to get the
heck out of it. Right. And you effectively Increased what you otherwise could have mitigated. So, you know, it’s
sometimes paying.
Speaker 2 – 34:50
You want to have optionality. Right. If you’re going to do this. So there are ways to safeguard yourself against that.
There’s a lot of times where, you know, you have degrees of owner separation. It’s only part of, you know, the
ownership group could reside inside a C corporation with eligible shares and you could sell part of that, but then
have this other entity or legal owner on the other side that may not be a C corporation. In the event that this doesn’t
work out, all right, we’re going to pivot and we’re going to ship. So you can never entirely eliminate the risk of an
asset deal occurring, but you can mitigate the implications. Remember, any downside protection always is always
accompanied by upside limitation. Right. So that’s your other big risk. Right.
Speaker 2 – 35:31
Is that a buyer who’s privy to anything tax, which sophisticated buyers always contemplate, tax, they’re going to
recognize that they’re giving up a benefit by doing a stock deal in the form of a future amortization or depreciation
on assets and a step up. Right. So they’re going to lose that shelter that they were otherwise going to get. And on
the back end of it, they’ve got this liability potential pickup rate that they’ve got it. So they may come in a
sophisticated manner, but honestly, and say, we’re not willing to pay you as much as we otherwise would if it’s
going to.
Speaker 3 – 36:01
But if you factor in the tax savings, it still could be a net win rate.
Speaker 2 – 36:05
And that’s where the modeling comes into play. Right. Is it worth us to forego the extra million bucks to get to
qualify under this regime? If it is, great, what’s my net benefit? And we didn’t talk about this a lot. We haven’t talked
about this a lot. But that’s something that we in particular focus on a lot, which is what, you know, headline
purchase price means nothing if you don’t contemplate structure and tax. So if we’re getting into these types of
conversations with our clients, it’s what does this look like? If it is a stock deal but not headline purchase price,
what’s the after tax consequence? Right. Or the after tax net proceeds and an asset deal? Same thing where our
after tax net proceeds. That’s how we know which levers to pull in which direction to go.
Speaker 2 – 36:43
And we’re also not shy about sharing that with prospective buyers whenever we’re entertaining the sale of a
company. So we want Them to know that we know that you guys are looking to receive this benefit. We want you
to know that we want to receive our benefit on our end. And they’re never going to align, right? What the buyer
wants is never going to directly align from a tax perspective of what the seller wants. But we can find a mutual
middle ground that satisfies both groups whether it’s a purchase price adjustment or whether it’s, you know, some
hybrid strategy, right, that gives us, gets them some level of step up. Maybe not all the way stepped up at some
level of step up, but affords us some gain protection on the other.
Speaker 3 – 37:18
What would be a hybrid like some asset sale, some stock sale, you could.
Speaker 2 – 37:22
Do some of that or you can have multiple, you know, entities. You say you have multi party transactions where
some of the parties qualify for this treatment and other parties simply don’t.
Speaker 3 – 37:31
Have you had any like specific types of buyers? That this is harder. And what I mean is like selling to private equity
versus selling to a competitor versus selling to whatever. Is there any that work better than others?
Speaker 2 – 37:45
I wouldn’t say that they work better than others. It’s. It always depends on how people like how the buyers are
situated. So this is a strategic sale, right? We go down the road of, you know, aligning you or selling you to either a
competitor or somebody who’s strategically situated in your industry. Then you’re kind of beholden to their
structure. Post sale, a lot of private equity groups, to the benefit of this strategy want to own C corporations
because of their investor pools and some of the manipulation, they call it the Alphabet shares that they try to
employ. So C corporations, you know, benefit private equity groups. So they typically aren’t that concerned
overstructure of buying a C corporation itself. What they’re going to be more concerned about is contractually what
does that mean to them from a liability perspective?
Speaker 2 – 38:30
What does that mean to them on the strategic side? You get into harder conversations because if they’re situated
in a way that they can’t own a C corporation, then you almost start to fall into the category of we have to do an
asset deal, right? If we did this now, we wouldn’t be doing our jobs if we didn’t advise these clients on how
prospective buyers are situated and what this means from a structure perspective to them. So that’s something
that we look closely at as well when we’re representing companies for sale or just working with them on the
accounting firm side to do real tax planning for future exit options.
Speaker 3 – 39:02
The qualified trader business. What doesn’t qualify what types of trades or services or business structures doesn’t
qualify?
Speaker 2 – 39:10
I don’t know that off the top of my head. But there are certain businesses that are just in quote unquote, SIN
categories that aren’t afforded this type of treatment upon departure. But off the top of my head, I don’t know
exactly what those businesses are.
Speaker 1 – 39:26
Services and health, law, engineering, architectures, what, finance.
Speaker 3 – 39:31
Right. Because we don’t qualify.
Speaker 1 – 39:32
Yeah, There’s a whole list under here,.
Speaker 2 – 39:34
At least per Claude, before it recently changed, it mirrored the QBI treatment.
Speaker 3 – 39:42
Okay.
Speaker 2 – 39:43
Or qbid. Right. And so QBID established a new foundational understanding of types of businesses. The SIN
businesses were us, right. Financial advisors, accountants, attorneys. And then they, for whatever reason, are
stipulating health and certain types of consulting. So basically, it’s anybody behind the desk that doesn’t
manufacture a product, you have to pay close attention to whether or not they’re going to do that. Now, that is a
little bit different. Under the newest version of this. I think that when we have to get into the details of it, when
Covid happened and the first tax law change occurred back in 2017, ish or whatever it was. Right. Not the first one,
but one of them. That’s when QBI was introduced and that’s when this stipulated group of quote, unquote, SIN
businesses was formed. That was never fully defined under the originally enacted tax law.
Speaker 2 – 40:37
So, you know, there are ways to shoehorn yourself into a category of business that qualifies. Even if you do some
of these things, you just have to be careful, right, about how you explain your business, how you define your
business and how it’s structured.
Speaker 3 – 40:52
What about this one? Is this 80% active business requirement?
Speaker 2 – 40:56
So that means that the owners that are passive inside these businesses aren’t afforded this treatment.
Speaker 3 – 41:01
Okay, so that you have to be an operator.
Speaker 1 – 41:05
Yeah.
Speaker 2 – 41:05
You have to be an owner. Operator of the business. You have to be active in the business. And you can’t just be a
passive shareholder that sits back and reaps the benefit of this type of strategy. I mean, the only thing that I would
say is that if you’re going to do this, right, and particularly if you want to get into these, like, stacking situations and
you want to maximize this benefit, that does require real forethought. Real forethought, real foresight and real
planning. Like I said, I think the biggest issue that people have is they get introduced to this when they’re selling
their business. So their optionality as far as how to enhance it is largely moot.
Speaker 3 – 41:39
So you have three to five year window, you gotta be under 75 million of assets or those are kind of your trigger
points.
Speaker 2 – 41:44
If you have any inkling that you’re going to want to sell your business in the near future and this could be
something that you’re eligible for, then you should think about structure now and you should try to employ or
engage, you know, the strategy in a defined way from that point till when you actually sell it.
Speaker 3 – 41:59
What about gifting upstream to parents? Can you do that?
Speaker 2 – 42:05
You can do that.
Speaker 3 – 42:06
So you could gift like I’m just thinking if one, let’s say you have a owner operator that kind of built it himself.
Parents aren’t super wealthy, gifted up, that could do a lot of things because then that money could be a sell tax
free, get invested, they get a step up or it could go into a trust and skip the operator. Right. So that could be a huge
benefit.
Speaker 2 – 42:31
Yeah, that’s the tricky part. So upstream gifts are, you know, just becoming more and more prevalent. People have
actually figured out a strategy where you gift upstream, you know, to an ill parent and you know, you wait for them
in the past and then just re inherited at a step up basis. The IRS is very keen on there. There is, yeah, there’s usually
a 6 to 12 month look back on what you’ve done. But long story short, that’s possible. And what I would tell you is
that it’s, it allows you to just further enhance the deduction or the, you know, the shelter that you’re going to get.
You should, if you’re going to do that, your parents should be in good shape, healthy, right. All the things like they
should be eligible as shareholders and you know, not simply a tax ploy.
Speaker 2 – 43:17
So the big risk you run when you overindulge in things like this is that it could be deemed a transaction. What do
they call it?
Speaker 3 – 43:27
A step transaction?
Speaker 2 – 43:29
Well, there’s step transactions, but this is more of like a tax shelter. Right. Is that, are we intentionally entering into
this transaction for the purpose of tax avoidance? If that’s the case, then the IRS has the ability to come in and
simply unwind it. Now I’ve never seen them actually do that, but there is, you know, there is risk there. Right. The
more you do this, what makes more sense, more meaningfully is to look at your immediate family and start there,
look at anybody you want to reward. Maybe, you know, start there and then enact a proper trust strategy. You have
five trusts.
Speaker 3 – 44:02
Are there any trust structures that don’t work for this?
Speaker 2 – 44:05
So Reb Trusts are harder to accomplish this with than irrevocable trusts. What do you typically look for is a
taxpayer. Taxpayers are afforded this benefit.
Speaker 3 – 44:13
So you want to do a non grantor trust generally, which makes sense a lot of times for taxes anyway, correct?
Speaker 2 – 44:20
Yeah. Now here’s your problem with that. As long as the company’s a C corporation, you’re fairly protected. Trust
taxation, particularly irrev trust taxation is unfavorable. You go from 0 to basically 40% tax after like 5000 bucks.
So you don’t want to be subjected to that, you know, on and on through pass through income to the trust. So the C
corporation existing as the tax paying vehicle at 21% plus state is a favorable outcome as long as you leave the
earnings in there and you don’t dividend upstream or out to the trust itself. The trust is essentially just an
ownership vehicle that should sit there and not necessarily partake in any of the earnings or distributions of cash
throughout its existence in order to preserve your tax dollars today, but also satisfy this requirement upon
departure date or sale.
Speaker 3 – 45:16
Are there any states that this is more scrutinized or doesn’t work as well?
Speaker 2 – 45:20
Every state’s different. So some states acknowledge this and other states don’t. This is no different than, you know,
a state that acknowledges reorganization type provisions. Right. So like Pennsylvania may have their own set of
rules and or versions of this than any other state that you look at. So off the top of my head, you know, all I can
really tell you is they’re all different. That level of research is required depending on where you operate in order to
determine whether or not this is going to be a state eligible deduction or if this is going to be purely federal.
Federal is federal no matter what. Right. That’s a global consideration for all parts of the business, state by state.
Speaker 3 – 46:04
Is is it eligible in some states? Some states will recognize it.
Speaker 2 – 46:08
There are states that will and there are states that won’t.
Speaker 3 – 46:11
So I guess if you’re in a no income tax state, you’re golden, right?
Speaker 2 – 46:15
Either way, I mean that’s the best bet, right? Be a Florida resident and sell your shares. Be a Texas resident and sell
your share of the states that permit that. That’s your best answer.
Speaker 3 – 46:26
And then the trade off. So like Pennsylvania for example, the C Corp tax is what, 10 or 8%? So you’re going to pay
an extra, you know, let’s say you’re doing it for five years. I don’t say your profits are 10 million bucks. That’s an
extra what, 8080 grand, no, 800 grand in tax each year. So for see if we can do this quick math for five years, that’s
33 point, no, $4 million. You’d pay extra in tax, something like that.
Speaker 2 – 46:59
I don’t trust your math on that one.
Speaker 3 – 47:02
So you may pay a little extra income tax on the C corp level along the way, but that would, you know, if you’re
getting 10 million of profit, 8 to 10 x multiple hundred million, that math usually works, right?
Speaker 2 – 47:15
Yeah, Yep. The issue with a C corporation is, you know, just like that daily, you know, operating implication of being
a C corporation versus being a more flexible vehicle. So this is one component of a C corporation that’s favorable.
In Contrast, there are 50 things about C corporations that aren’t favorable. One of them is the heightened state
income tax rate. They’ve actually fixed the federal rate to be more commensurate with what your marginal pass
through rate will be. And a pass through type federal.
Speaker 3 – 47:46
State’s federal rate’s 20, right?
Speaker 2 – 47:48
21.
Speaker 3 – 47:48
21. It was 28.
Speaker 2 – 47:50
It was 28.
Speaker 1 – 47:51
Yeah.
Speaker 2 – 47:52
It’s been as high as 35. Right. So it’s just, that’s a lot.
Speaker 3 – 47:55
So walk through. If you’re an owner, you get taxed at the corporate level at 20 plus state and then passes through
on a W2 and you pay your. Right, your wage.
Speaker 2 – 48:07
So not necessarily a W2, but so corporations have the ability. The, the cheapest tax outcome in a C corporation is
paying tax at your, I call it. If it’s a PA based business, you know, you’re essentially 29 to 30% in corporate tax. So as
a part of the C corporation itself, then whatever money’s left after that tax is gone can be sent out via dividend to
an ownership group. Now that’s subject to another 20% tax and potentially net investment income tax on your
individual income tax return. So long story short, you’re talking about an effective income tax rate of substantially
higher than that 29% that you’re talking about that headline one.
Speaker 2 – 48:48
So once it gets base level, the only way to circumvent that is to drive, and this is an age old strategy, drive your
earnings in the business down to zero by bonusing 100% of that income out to you. So the C Corporation
effectively reports zero and your W2 wage reflects all of the earnings of the business and then you pick that up at
your marginal rates. Individually that’s a fine strategy and it’s something that you can do to manage the cash flows
of the business and your tax implication inside the C Corporation, but it does create angst as far as payroll tax
implications are concerned.
Speaker 3 – 49:21
So let’s just example, let’s say there’s a million bucks in profit. If you wt yourself out, you’re going to pay 30,
probably 35, 36% if you leave it in.
Speaker 2 – 49:34
What’s the do you leave it in the C Corporation, you’re going to pay 29% on it. Right. But you can’t take the money
out, you got to leave it in the C corporation. So all that cash just rests in equity until you’re ready to do something
with the business.
Speaker 3 – 49:49
Okay.
Speaker 2 – 49:50
And there’s no way out of that. Right. That’s the biggest hang up on a C Corporation. They fixed the federal rate
which was a huge issue over the past few years. Well I should say pre Trump’s first term. And then now that is
fixed, the real hang up is that the departure of cash from a C corporation just creates that additional or that second
layer of tax that really amplifies what your effective overall tax rate is. If you look at both parties, if you look at it
individually, C corporations can be great. But if you look at it globally with you in mind as the owner or with an
ownership group in mind, your effective income tax rate has the capacity to be higher than your marginal rate as an
individual.
Speaker 1 – 50:35
And the more you manipulate on the C Corp side, the just, there’s risks that pop out. So if you’re bonusing
everything out, then there’s reason. Right. And you know, sometimes people will do shareholder loans, which we
don’t like from a tax or accounting perspective and they’ll take the cash out tax free as a loan from the company.
Now you just have that sitting on the balance sheet as an asset. And you know, do you have it on paper? Are you
charging it? There’s all kinds of things at the.
Speaker 3 – 51:13
Time of like take a loan out, sell, get the tax free proceeds, pay it back or does that mess up the transaction? Like
is the buyer going to be like what you know, there’s this loan here. Could you take a loan tax free, have an interest
rate and then sell, you get the exclusion of 15 million tax free and then pay the loan back.
Speaker 1 – 51:38
Yeah, you have to pick up the income, the interest income and interest expense on both sides and you have to have
paper on it. Like you have anything that you’re going to do. If you’re looking to support it has to be real and you
have to have paper behind and actually do it.
Speaker 2 – 51:53
Bona fide loan under market terms. Right. And it’s not just an accounting thing, right. That people want to see that
the form follow the, you know, the function of the whatever you’re putting in place. So if it’s a loan, right, you want
to charge interest under market terms. You want the term of the note to be a certain event. So anyways, long story
short is that’s possible and it’s doable, but you just be it, do it legitimately. Yeah.
Speaker 1 – 52:18
And you would end up paying that cash when you repay it, if you’re then distributing it out of the C corp in a sale,
you’re going to pay dividend. So like Annie was saying, sometimes people get obsessed, absolutely obsessed with
not paying tax and either take risks that they shouldn’t or they just do things from a business perspective that they
shouldn’t. Like we tell clients it’s okay to pay tax means you made a lot of money, right? Like, you know, if you don’t
need another truck, don’t buy another truck.
Speaker 3 – 52:54
That’s a good one. Because it’s like, okay, I’m gonna buy a hundred thousand dollar vehicle and save 40%. Well,
you’re still paying 60 grand for the vehicle. You know, you’re still cash out of pocket, right.
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Transcription).mp4
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Speaker 1 – 53:04
Or you’re borrowing, you’re, you know, you gotta pay the debt back on that. So yeah, it’s not, you know, paying a little
bit of tax is okay, we’ll minimize, help you minimize it. But you know, nobody pays no tax other than people that are
broke.
Speaker 2 – 53:24
Think about it this way, right? So your focus shouldn’t be paying $0 in tax. Your focus should be effectively creating
a scenario where your effective tax rate on the proceeds that you’re receiving is as low as it can possibly be. There
are no tax elimination strategies. This is one that affords you the opportunity to shelter some of your tax. But
under very specific circumstances, these are not common throughout the Internal Revenue Code. So people that
obsess over this ultimately have the capacity to hurt their business because they’re more focused on not paying
tax than maximizing value. And your best bet is to find a balance, right. You want to run the company effectively
create, you know, inherent value to a buyer for them. Right. And for you along the way.
Speaker 2 – 54:09
But on the back end of it, if you can be afforded this, use it, right? If you can’t, don’t overextend to try and recreate
something that’s going to make this happen. Unless it’s really going to be a favorable tax savings. The going all the
way back to the beginning, the group that Tom was talking about at the beginning, that we structure or structuring,
you know, them into this, they will have a tremendous benefit from this. You know, this company’s probably going
to be worth well over $100 million, maybe more later on. Right. Not too far from now, if it’s not already. So they’ll
have an opportunity through this structure for a lot of reasons to say, hey, you know, like, we have to do a stock
deal. It makes sense.
Speaker 2 – 54:50
We may give a little bit on that, but the tax savings associated with this being in place is going to be so
monumental that any type of, call it, give on the headline purchase price side is more than compensated for or
subsidized by the tax savings. So when you get into the $5 million deals where you’re like, okay, we don’t want to
bend over for a buyer or personally in the business to enact this type of strategy because we’re really not saving
anything on the back end of it. What it’s going to cost us is going to equal what the tax savings would have us.
Speaker 3 – 55:22
Cool. Well, I think it covered pretty much everything. So Tom andy are the experts here. In any type of transaction
QSBs, if you’re thinking of doing any of these strategies, reach out and, you know, these are the guys to talk to.