Startup Founders and Estate Planning in California: QSBS, Trusts, and Pre-Liquidity Strategies

For California startup founders, wealth often arrives all at once — and so does the tax bill.

Early-stage equity may seem like little more than a piece of paper. But when a company grows, those seemingly abstract shares can transform into multi-million-dollar stakes. That wealth, though, is typically concentrated, illiquid, and taxable. Without careful planning, founders risk losing a substantial portion to capital gains, estate tax, and unintended legal consequences — particularly in high-tax states like California, where planning must navigate both federal and state rules.

This article outlines how founders and early-stage investors in California can proactively plan around Qualified Small Business Stock (QSBS) and other assets using trusts and gifting strategies. These tools can remove appreciating stock from the estate, multiply QSBS tax exclusions, and preserve wealth across generations.

But none of this is automatic. These strategies are complex and closely scrutinized by the IRS and California's Franchise Tax Board. They work only when done early — and done right.

1. The Unique Nature of Startup Wealth in California

Startup equity is unlike any other asset class. It’s:

• Illiquid — You can’t easily sell it to pay taxes or expenses.
• Volatile — Company valuations can change dramatically in short periods.
• Highly concentrated — Founders may have a large percentage of their net worth tied to a single entity.
• Potentially tax-advantaged — If structured correctly, startup stock can qualify for generous tax exclusions under federal QSBS rules.

In California, this complexity is multiplied by state income tax rates, lack of conformity with federal exclusions, and residency-based trust taxation. Founders need to address tax exposure, liquidity timing, ownership structure, and family planning — ideally years before a liquidity event.

2. What Is QSBS and Why It Matters in California

Qualified Small Business Stock (QSBS) under Internal Revenue Code § 1202 allows for up to a 100% exclusion of capital gains upon sale — up to the greater of:

• $10 million, or
• 10x the original basis in the stock (IRC § 1202(b))

To qualify:

• The stock must be originally issued by a domestic C-corporation (IRC § 1202(c)(1))
• The company’s gross assets must be under $50 million at the time of issuance (IRC § 1202(d)(1))
• The stock must be held for at least five years (IRC § 1202(b)(2))
• The company must be engaged in a qualified active business (IRC § 1202(e))

Important for California founders: California does not conform to federal QSBS rules. As of 2024, California fully taxes gains from the sale of QSBS, regardless of federal exclusions. This position stems from the California Revenue and Taxation Code and was clarified in FTB Legal Ruling No. 2014-01. Therefore, state income tax remains payable unless offset by other strategies.

3. Using Trusts to Multiply the QSBS Exclusion

A common strategy is to create non-grantor irrevocable trusts, each of which can hold QSBS and claim its own $10M+ exclusion under IRC § 1202. The founder removes appreciating stock from their estate, multiplies the federal QSBS exclusion, and structures gifts to benefit children, spouses, or other heirs.

Trust structures used include:

• Non-grantor dynasty trusts (long-term, multigenerational vehicles)
• Spousal Lifetime Access Trusts (SLATs) to preserve family benefit while removing assets from the taxable estate
• Charitable Remainder Trusts (CRTs) for philanthropic and tax deferral advantages

Timing is critical. If a founder transfers QSBS into a trust after a liquidity event is in motion, the IRS may challenge the transaction under the step transaction doctrine (IRC § 61; judicial doctrines), arguing the gift was a post-sale assignment of income.

Hypothetical: Timing and Trusts in Action

Lena, a founder in Irvine, owns QSBS in a high-growth AI company. Her shares, purchased at a nominal value in 2020, are now worth $12 million.

In 2023, before any deal or negotiations are underway, Lena works with her California estate planning attorney to establish two non-grantor irrevocable trusts: one for her spouse (a SLAT) and one for her daughter. Each trust is funded with $4 million worth of shares while the valuation is still modest. She retains $4 million in her revocable living trust, as her sole and separate property.  

By 2027, when the company is acquired, the shares have appreciated to $10 million per trust, and $10 million in Lena's name. Because each trust qualifies as a separate taxpayer under IRC § 1202, each exclusion can apply individually:

• Lena: $10M excluded
• Spouse’s trust: $10M excluded
• Daughter’s trust: $10M excluded

The result: $30 million of capital gains excluded from federal tax, compared to $10 million if she had held all the stock personally. The strategy also reduces her estate, with the growth in value occurring outside of her taxable estate.

This strategy worked because it was implemented well in advance, with proper structure, arms-length transfers, and no binding sale agreement in place.

4. Risks and Tax Scrutiny in California

These techniques are effective only when executed properly. Key risks include:

• Step Transaction Doctrine (Gregory v. Helvering, 293 U.S. 465): The IRS may collapse pre-sale transfers if a binding agreement exists.
• Substance Over Form Doctrine: Courts may recharacterize a transaction if it lacks true economic substance.
• Assignment of Income Doctrine (Lucas v. Earl, 281 U.S. 111): Transferring an asset just before realizing income may result in tax being attributed to the transferor.

California imposes its own sourcing rules under California Revenue & Taxation Code § 17951 and may treat a trust as a California taxpayer if:

• The trustee is a California resident
• A non-contingent beneficiary is a California resident (Cal. Code Regs. tit. 18, § 17951-4)

Careful attention to trust situs, trustee residency, and administration location is essential when designing non-California trusts for California founders.

5. Additional Planning Tools for California Founders

California founders nearing liquidity may also consider:

Charitable Remainder Trusts (CRTs)

• May defer federal capital gains tax (IRC § 664)
• Distribute income over time
• Remainder interest goes to charity
• California may still tax gain if sourced to the state under R&TC § 17952

Direct Gifting Using Lifetime Exemption

• The federal estate and gift tax exemption is $13.61M in 2024, scheduled to drop to ~$6-7M in 2026
• Early gifts allow use of the higher exemption
• Gifts of closely held stock require formal appraisals (IRS Form 709)

Donor Advised Funds (DAFs)

• Provide immediate federal charitable deduction (IRC § 170)
• Can offset income post-exit
• Useful for liquidity planning, though California conformity may vary

Final Thoughts: Pre-Liquidity Planning for California Founders

If you’re a California-based founder, startup wealth presents a rare opportunity — and a serious tax challenge.

Done properly, pre-liquidity strategies can:

• Multiply federal tax exclusions under QSBS (IRC § 1202)
• Remove appreciating assets from your estate (IRC § 2031)
• Create lifetime income or philanthropic impact
• Address California-specific trust and income tax rules (R&TC §§ 17041, 17951)

But these techniques are not plug-and-play. They require coordination, timing, and experienced legal guidance. The key is to start before the term sheet is signed.

Disclaimer: This article is for informational and marketing purposes only. It is not intended as legal, tax, or financial advice and does not create an attorney-client relationship. Estate planning strategies must be evaluated based on individual circumstances and should be discussed with qualified legal and tax professionals. Always consult your advisors before implementing any planning technique described herein.