A significant tax incentive designed to foster entrepreneurship and investment in startups, known as qualified small business stock (QSBS), is facing increased scrutiny and legislative action from several U.S. states. This federal tax break, enhanced by the One Big Beautiful Bill Act (OBBBA), allows investors and founders to exclude substantial capital gains from their taxable income when selling stock from qualifying C corporations, provided the stock has been held for at least five years. The OBBBA notably increased the maximum exclusion from capital gains taxes to $15 million, up from $10 million or ten times the original investment basis, and raised the asset limit for qualifying small businesses from $50 million to $75 million.
However, this lucrative tax advantage, which disproportionately benefits high-net-worth individuals, is now the target of new state-level legislation. Recent moves by Maine and Oregon to decouple from the federal QSBS exemption mean that residents in these states will now be subject to state income taxes on gains realized from selling QSBS. This development has sparked concerns among legal professionals advising wealthy clients, who suggest it could discourage entrepreneurial activity and prompt wealthy investors to reconsider their state residency.
David Blum, partner and chair of Akerman's national tax practice group, noted that "Tax policy has consequences, both good and bad, and I think that the states need to figure out what makes the most sense for them." He pointed out that individuals anticipating significant financial exits from their businesses may already possess multiple residences, making them more amenable to relocating to states with more favorable tax environments. This trend is exemplified by the high-profile departures of billionaires from California, partly driven by proposals for a state wealth tax, with figures like Google co-founder Sergey Brin actively supporting initiatives to counter such measures.
The QSBS exemption, originally established during the Clinton administration, aimed to stimulate the creation and growth of small businesses by incentivizing investment. The federal government allows for the exclusion of capital gains, but the OBBBA significantly amplified this benefit. The legislation's enhancements have made the tax break even more attractive, leading some states to re-evaluate its impact on their own tax revenues and economic landscape.
While Maine and Oregon have enacted legislation to tax QSBS gains, similar proposals in New York and Washington state did not advance. The District of Columbia Council's attempt to decouple from certain OBBBA provisions was ultimately blocked by a resolution passed by Congress. Currently, four states already impose state income taxes on QSBS gains: Alabama, Mississippi, Pennsylvania, and California, which is a major hub for venture capital activity.
Proponents of QSBS reform argue that the regime primarily benefits the wealthy. Research by the Department of Treasury found that taxpayers who earn more than $1 million account for nearly 75% of gains excluded. This concentration has fueled arguments that the tax break primarily serves as a wealth-building tool for the affluent rather than a broad economic stimulus.
Lawyers specializing in high-net-worth individuals, such as Steve Oshins, told Inside Wealth that QSBS laws and other tax proposals aimed at the wealthy encourage high earners to move to other states. The tax burden depends on where the shareholder lives when they sell their stock, which gives clients time to plan. Oshins said it is possible in some states to use trusts to avoid state income taxes on QSBS. Delaware, Nevada and Wyoming are popular jurisdictions for establishing these trusts.
For instance, Oshins explained, a resident of Oregon could transfer stock to an incomplete non-grantor trust set up in a state that doesn't tax trust income, like Nevada. As long as the trust is not administered in Oregon and none of the trustees live there, the trust's capital gains would not be subject to Oregon income taxes. However, states like Maine have more stringent rules, he said. Non-grantor trusts are subject to state income if funded by a Maine resident or created by the will of one, according to Oshins.
Despite the availability of trust-based strategies, Oshins indicated that for some clients, the most straightforward course of action is to move. He described scenarios where clients, contemplating a move, might delay formalizing their relocation until after establishing trusts in their new, more tax-advantageous states. "Let's say a client is about to hire me and says, 'I have a summer home in Florida, I'm thinking of moving there,'" Oshins said. "I'll say, 'Let's wait a few months. Move there. Then let's set up your trust.'"
However, Blum cautioned that altering one's legal domicile is a complex process that requires more than superficial changes like updating voter registration or spending a minimum number of days in another state. Tax authorities scrutinize these moves rigorously, and individuals must demonstrate a genuine intent to establish a new primary residence, often involving significant personal and financial ties to the new location. "When it comes to changing residency and your domicile, you really have to move and uproot your life," he said. Simply owning property in another state is insufficient; a true change of domicile necessitates a substantial uprooting of one's life and established connections.
The evolving state-level approach to the QSBS tax break highlights a broader debate about tax fairness and the economic impact of incentives aimed at the wealthy. As states grapple with budget pressures and differing economic philosophies, the future of such tax advantages remains a dynamic area of policy development, potentially influencing investment decisions and geographic distribution of wealth.
