There are so many considerations that go into buying a particular security or applying an investment strategy that it’s easy to forget or forgo tax efficiency. But for high-net-worth investors, some investments can generally help reduce tax exposure.
1. Qualified Small Business Stock
For investors who meet the requirements, qualified small business stock (QSBS) offers an extraordinary tax break. When QSBS acquired today is sold, 100% of the capital gain up to the greater of 10 times the initial
investment or $10 million is excluded from income, provided requirements are met.
QSBS was created more than 30 years ago by Internal Revenue Code Section 1202 as a tax incentive for investments in “small” businesses. Initially, 50% of the gain was tax-free, but Congress raised the exclusion to 75% for stock issued after February 18, 2009, and to 100% for stock issued after September 27, 2010.
Sales of QSBS are also exempt from the 3.8% net investment income tax and, for stock issued after September 27, 2010, from alternative minimum tax.
The tax incentive typically is available for qualifying QSBS issued after August 10, 1993.
But shares must have been issued by:
- A domestic C corporation whose aggregate gross assets were $50 million or less at any time after August 10, 1993, and immediately after the stock was issued,
- An active business, meaning it uses at least 80% of its assets (with certain exceptions) to conduct one or more active businesses, and
- An eligible business. Ineligible businesses include those involved in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, investing, farming, oil and gas, mining, and hospitality.
The tax break is available to individuals and trusts, as well as certain pass-through entities. To qualify for the exclusion, investors must acquire the stock directly from the corporation or an underwriter in exchange for money or property. They (or their heirs) must hold the stock for at least five years.
Note that there are some disadvantages to owning QSBS. Investments in small companies can be risky, so it’s important to weigh those risks against potential rewards. Also, the five-year holding period can cause investors to hold the stock longer than they would otherwise, potentially losing early gains should the stock’s value then decline. There’s also a risk that the benefits will be lost if, for example, the company ceases to meet the active business requirement.
2. Exchange Funds
It’s not unusual for investors to end up with heavy concentrations of certain stocks in their portfolios. This can happen if, for example, you inherit a large block of stock or receive stock shares when you sell a business. In such situations, you may wish to rebalance your portfolio, but could be concerned that rebalancing would generate sizable capital gains taxes.
One potential solution is to take advantage of an exchange fund (or “swap” fund). These funds allow investors to swap their concentrated stock holdings for shares in a diversified fund, without triggering capital gains tax. Exchange funds invest in a diversified mix of stocks — they’re often designed to track the S&P 500 or another market index — potentially reducing investors’ overall risk.
Keep in mind a few caveats. Exchange funds are usually restricted to “accredited” investors with substantial investable assets. Also, assets will be tied up for a seven-year holding period.
Beyond Taxes
You should never make investment decisions based on taxes alone, but tax efficiency can be a critical factor. Your Lenox Advisor can help you evaluate these and other strategies for making your portfolio more tax-efficient.
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