Stacking and Packing – Strategies to Maximize the Section 1202 Exclusion

These two strategies can be deployed together or separately, and they can significantly increase the exclusion available under section 1202, often by a factor of 2x or more. It is never too early to start planning for an exclusion under section 1202, and even if you are a few years away from selling your business, these strategies should be considered today.

Section 1202 generally provides for the full or partial exclusion of capital gain realized on the sale of qualified small business stock (QSBS). The requirements are summarized here. If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) a cumulative limit of $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). Both of these limitations apply on a per-issuer and per-taxpayer basis, and while section 1202 limits the exclusion to the greater of the two rules, in practice, the $10 million rule is most often the limiting factor for selling shareholders.

The section 1202 limitation applies separately to each “taxpayer.” A taxpayer for purposes of section 1202 is an individual, trust, estate, partnership, or S corporation. Stacking involves increasing the number of taxpayers that can take advantage of an exclusion under section 1202. Instead of one taxpayer taking a $10 million exclusion, the taxpayer can transfer some portion of his/her stock to another taxpayer and then “stack” the transferee’s exclusion on top of his/her exclusion.

Gifting QSBS between spouses is an obvious strategy because they are each separate taxpayers. If they file separate tax returns, however, inter-spousal gifting does not work because of a special rule in section 1202 that splits the limitation between them. If they file joint tax returns, it may be possible to stack the limitation, but section 1202 is awkwardly worded and it is often times easier to avoid the issue through the use of trusts.

Stacking works especially well for gifts to family members that can be incorporated into one’s estate plan, but it also works well for transfers to certain non-grantor trusts. In the trust area, some popular strategies involve the use of DINGs (Delaware incomplete non-grantor trusts) and NINGs (similar Nevada trusts), but these trusts should be structured only by a knowledgeable tax professional with estate planning expertise.

This strategy involves a taxpayer trying to stuff (or pack) as much basis into the annual exclusion (i.e., 10x basis) calculation as she can in order to increase the section 1202 limitation beyond $10 million. There are two ways this can be done.

The first method involves the taxpayer contributing cash or property worth more than $1 million to the issuer in exchange for QSBS. The property can be cash in excess of $1 million, appreciated property (other than stock) whose fair market value (FMV) exceeds $1 million, or a combination of both. This method works because of a special rule that determines the taxpayer’s basis for purposes of section 1202 by reference to the FMV of the property contributed. The taxpayer can then use the increased basis in the annual exclusion calculation. For example, if a taxpayer contributes $1 million cash and $3 million of self-created (i.e., zero basis) goodwill to a C corporation, then the taxpayer’s basis for purposes of the annual exclusion calculation is $4 million rather than $1 million, which is the basis for tax purposes other than section 1202. This means the taxpayer’s annual exclusion is $40 million, or 10 times $4 million.

This strategy can be used by any section 1202-eligible taxpayer with appreciated property, but we see it most often used in cases where a partnership converts an ongoing business (with appreciated property) to a C corporation, and where an S corporation transfers an ongoing business (with appreciated property) to a new subsidiary that is a C corporation.

The second method is a little more complicated but works equally well. It involves selling QSBS (with lots of built-in gain) during the same tax year that the taxpayer sells other high-basis QSBS (with little or no built-in gain) that may or may not meet the 5-year holding period. The goal is to increase the total basis of QSBS sold during the taxable year because the annual exclusion calculation is determined by reference to the total basis of QSBS sold during the year, regardless of whether the gain is currently eligible for an exclusion under section 1202.

For example, consider the case of a founder who formed a C corporation 6 years ago with $10,000. It is now worth $200 million and the stock is QSBS. If the founder sells half of his stock in 2021, then he has gain of $99.995 million ($100 million proceeds less $5,000 basis) but can exclude only $10 million (i.e., the greater of $10 million or $50,000 – 10 times $5,000 basis). But if the founder sells other high-basis QSBS during 2021, such as QSBS received earlier in the year from the exercise of stock options where he paid $2 million for the stock, then he can exclude gain of $20.05 million (i.e., the greater of $10 million or $20.05 million – 10 times $2.005 million basis). The founder has effectively doubled his section 1202 exclusion by packing his basis to take advantage of the annual exclusion rather than the $10 million exclusion.

Stacking and packing are excellent strategies to increase the section 1202 exclusion, but planning for them should not be put off until the last minute. When it comes to gifting, for example, the sooner the gift is completed, the stronger the tax analysis, particularly if a sale of the business is contemplated.