11 posts categorized "Taxes"

The 1202 Planning Opportunity

Since Joe Wallin first broke the news nationally (best I can tell) that the fiscal cliff bill included revival of a previously expired 100% exclusion from capital gains tax for certain holdings in QSB stock, people have been wondering on Twitter why no branded financial or tech media outlet has picked up the story.

1202It's a fair question, particularly when you consider that big media properties have been reporting on other "tax extenders" in the fiscal cliff bill. 

A partial answer may be that there is nothing outrageous or scandalous about the QSB exclusion. Whereas the tax breaks in the fiscal cliff legislation for Hollywood movie production, for electric scooter manufacturing, for NASCAR race tracks, and the like, are laughable, or tragic, or both, and so more fun to talk about. (See for example this entertaining piece by Brad Plumer in the Washington Post, From NASCAR to rum, the 10 weirdest parts of the ‘fiscal cliff’ bill.)

A better answer may be that the exclusion for QSB stock is so difficult to explain.

Here's a paragraph from a post Joe wrote in the summer of 2010, summarizing what QSB stock is:

In general, 'qualified small business stock' is stock in a C corporation acquired by a taxpayer at its original issue if as of the date of issuance such corporation was a 'qualified small business,' and during substantially all of the taxpayer’s holding period for such stock, the corporation met certain active business requirements and was a C corporation. A 'qualified small business' in general means a business with less than $50 million in gross assets. The active business requirements require that at least 80 percent (by value) of the assets of the corporation be used by the corporation in the active conduct of 1 or more 'qualified trades or businesses.'

Much to chew on there, and you must also slog through the analysis of whether or not you are dealing with one of the "qualified trades or businesses."

Get those fundamentals settled, and you're still not done: you have to hold the stock for 5 years. And the exclusion from capital gains tax applies *only* to your initial $10 million in gain.

Among the planning opportunities this fiscal cliff tax benefit affords:

  • A chance to weigh whether a C corp makes more sense for the structure of your new business than an LLC or other alternatives;
  • Whether you should convert your LLC into a C corp before the benefit expires at the end of 2013;
  • From the investor perspective, whether you can negotiate reps and covenants in your investment documents to give you and others in the deal a fair shot at meeting the requirements of the exclusion; and
  • From the perspective of an employee, whether you should exercise a stock option in a timely way.

This is complicated stuff. Even if you master the rules in the abstract, you are likely to yet need advice from a good accountant and/or a tax lawyer. But it may be worth the effort.

Here are some references to help us all get (re)started (caution, all of these were prepared in the context of the exclusion in prior incarnations):

Photo: Tom Magliery / Flickr.

Fiscal cliff compromise includes tax incentive for angel investing

Yesterday, Joe Wallin blogged about what many may consider a surprise provision in the fiscal cliff compromise legislation.

The provision is a resumption of a tax benefit for angel investing in startups.

Voting in House finalThere are strings and conditions, of course, but essentially it gives angels the benefit of a zero capital gains rate for investments made in "qualified small business stock" that is purchased within a set time frame and held for a minimum number of years.

Startups benefit as the recipients of the additional private investing spurred by the tax incentive; the funded startups then take those investment dollars and create jobs.

As usual, Joe's got the technical details on his blog.

I asked Joe a few follow up questions by email, and below are his replies.

Questions for Joe Wallin:

Q: Joe, the House last night approved the Senate compromise on the fiscal cliff. It seems like it's essentially a tax bill. You wrote in your blog yesterday that this fiscal cliff legislation actually includes a tax break to encourage angel investment in new companies?

A: Yes, it does. It renews the 100% exclusion under Section 1202 for investments made prior to the end of 2013.

Q: But that 100% exclusion had expired a year ago, had it not?

A: Yes, it had expired at the end of 2011.

Q: So if the 100% exclusion is retroactive to include investments made in 2012, after expiration of the exclusion at the end of 2011, what's the policy rationale? It's too late to make any new investment decisions in 2012. Why not make the exclusion pick up again at investments made in 2013 and going forward?

A: It definitely does apply to investments made in 2013. As for investments made in 2012, it may incentivize investors to meet the five year holding period. Patient investors are good for startups.

"Drag It Out" Covenant

By way of follow up to Monday's post, here is a rough draft of a boilerplate "drag it out" covenant. The exercise is to model a concession that founders might ask from investors who may eventually take control of the board and represent a majority of the equity, in order to preserve the possibility that the founders could realize the potential tax benefit of the recently-extended 100% exclusion from capital gains of certain QSB stock purchased before January 1, 2012 and held for five years.

x.y Drag It Out Right. In the event that (i) the Board of Directors proposes, recommends, approves or otherwise submits to the shareholders of the Company, for shareholder action, a Deemed Liquidation Event, and (ii) a Holder has not received written notice from the holders of a majority of the shares of Key Holder Common Stock that such holders approve the Deemed Liquidation Event, then such Holder hereby agrees to vote (in person, by proxy or by action by written consent, as applicable) all shares of capital stock of the Company now or hereafter directly or indirectly owned of record or beneficially by such Holder against the Deemed Liquidation Event, to assert statutory dissenters’ rights with respect to the Deemed Liquidation Event, and to take such other action in derogation of the Deemed Liquidation Event as shall be requested by the holders of a majority of the shares of Key Holder Common Stock in order to carry out the terms and provision of this Section x.y. This Section x.y shall expire on [insert date five years from last significant founding issuance] and thereafter be of no further force or effect.

Tax Free Exits for Founders and Investors Alike

Most of the discussion about the 100% exclusion of capital gains from the sale of "qualified small business" stock, extended now by the new tax law for stock purchased prior to January 1, 2012, has been about the enticement it represents for angels and other early-stage venture investors to fund more startups. 

But as George Grellas deftly lays out in a post last Friday on Hacker News, the benefit may well be available to startup founders as well:

"Who is a qualified buyer of such stock? The exclusion may be claimed by any "taxpayer" who meets the statutory requirements. It is not limited to "investors" but includes anyone who buys stock in a qualifying corporation and otherwise meets the section-1202 tests. This would include founders.

"...[T]he stock must be acquired by the taxpayer in exchange for money or other property (not including stock) or as compensation for services provided to the corporation (this was the rule historically under section 1202 but please confirm with a good CPA or tax lawyer to make sure this carries forward during the 100% exclusion window - I think it does but am not 100% sure - to be safe, pay cash). Nothing in the rules specifies that the amount paid has to exceed any particular sum and so the amounts typically contributed by founders should generally qualify."

And the same logic ought to yield a prescription to stock option holders: no later than the end of 2011, seriously consider whether the various conditions of the exclusion are likely to be met and, if so, consider exercising any portion of your option(s) then vested. (Note: my prior post on this point was written when the exclusion was due to expire at the end of this month. Just to be clear, the new tax law expands the exclusion for an additional year, through 2011.)

There are conditions (of course there are!) to receiving this benefit. Check Joe Wallin's and Asher Bearman's & Trent Dykes's posts for more detailed explanation of the how's and must's. George Grellas's post is also a terrific and readable overview. 

But let's focus for a second on just one of the conditions, a requirement that the qualifying small business stock be held for a period of five years. Might founders and investors alike have an incentive to not sell the company at year 4.5 on the timeline, say? 

Let's entertain a more troublesome hypothetical: suppose the company was formed and that the founders purchased their shares last month, but that the first outside investors don't come in until December, 2011, just before the purchase window for the exclusion expires. Then suppose an offer to buy the company is received in the fall of 2014. Assume the outside investors want the company to take the offer. Perhaps they feel the price and timing are right; and in any case, from their perspective, the potential benefit of the capital gains exclusion is still two years of additional risk, uncertainty and the potentially stronger competitors away. The founders, on the other hand, see the benefit on a rising horizon. If they can delay an exit for just one year, they and their families stand to receive a potentially huge tax benefit. 

It's making me think there would be utility in a "delay of exit" covenant for the parties to consider in connection with a preferred stock round. It would be like a drag along covenant, but for a contrary purpose: it might slow the entire ship until one or more classes of shareholders could reach (their respective) five-year holding period(s).

We'd call it the "drag it out" covenant!

Update 12/24: I've since posted a brief, model "drag it out" covenant, here.

Dividend and Capital Gains Tax Rates to Track Through 2012

Just a brief update by way of keeping tabs on a concern previously raised on this blog: the new tax law signed by the President yesterday retains a 15% tax rate on capital gains and dividends through 2012. This is lower than a 20% rate for capital gains that the administration had been advocating earlier this year.

The law also extends the exclusion of 100% of capital gains from the sale of "qualifying small business stock." (Joe Wallin is the most consistent of the "Law Crunch" bloggers posting on this exclusion, how it works and its conditions; see his recent post here). But, as pointed out by an expert I heard speak privately yesterday, this extension is not in synch with the rest of the tax bill, which generally applies to behavior through 2012. The 100% exclusion is only extended to QSB stock acquired before January 1, 2012.

Tax Tails Wagging the Business Dogs

Joe Wallin posted a creative thought on his blog last week:  use the extraordinary, temporary opportunity to get 100% exclusion of gains on QSB stock to convert your LLC into a C-Corp. (It's complicated; details here). I posted recently as well about the possible merits of exercising vested stock options by the end of the year, in light of the temporary tax opportunity.

There may be other creative uses of this quirky law. It may have been intended to encourage more angel investment by the end of the year, but most of the folks I know who've thought about it agree that, if spurring additional angel and startup investment was the desired impact, the break would really need to be in place permanently, or for a longer period of time.

Asher Bearman has a really accessible primer on the whole QSB stock issue, what the ground rules are, what the benefits can be, and perspective on historical tax rates that give enough context for the discussion to "take." See his post here.

Joe's creative suggestion is largely predicated on the normative assumption that the LLC may eventually sell out, have a liquidity event. You can't always control the timing of such an event, but why not prepare and get the advantage of the exclusion of gain, if the circumstances happen to fall out in a way that would make that benefit available?

But taxes, or the prospect of imminent changes in tax rates, are also causing some emerging companies to go the other way, that is, to convert from a C-Corp to an LLC!

The companies of which I speak are perhaps a subset of emerging companies, and some would say should not even be in the "venture" category, as that term has traditionally been understood. These are growing, emerging companies that can see a clear alternative to the traditional exit strategies of IPO or sale of the business: run the business to throw off cash to investors year after year. If this "exit strategy" or "anti-exit strategy" is viable for a given company, then the prospect of running the business with the advantages of passthrough taxation can be pretty attractive.

Converting from a C-Corp to an LLC can be prohibitively expensive, tax-wise, in that the conversion itself will be taxable at two levels: on the deemed sale of the corporation's assets, and then at the shareholder level on the deemed distribution of proceeds to them. Although it may be attractive to get to the "promised land" of passthrough taxation, it may kill you to cross that mountain.

But for some emerging companies taking the "no exit" path seriously, there will be a "sweet spot" that can make converting from C-Corp to LLC viable. See this "case study" by Albert Ellentuck on the American Institute of CPAs' website.

"In general," Mr. Ellentuck writes, "a corporate conversion may be desirable if:

  • The corporation holds assets that have not appreciated or that have depreciated. . . . 
  • The corporation . . . [has] NOLs or capital loss carryforwards that absorb any gain recognized on the liquidating distribution. . . . 
  • The corporation holds assets that will appreciate rapidly in the future (such as intellectual property or real estate). . . ."

That's just a conceptual framework; there are devils in the details, numbers to be run, appraisals to be commissioned, etc.

Possible Tax Planning Opportunity for Startupers with Vested Stock Options

Should you exercise the vested portion of your stock options before the end of this year, to get the maximum potential tax benefit from the temporary 100% exclusion of capital gains on the later sale of Qualified Small Business Stock?

That question was a mouthful! The issues are complicated enough to require background on terminology and explication of the rules. If this topic interests you, be sure to read Joe Wallin’s recent post on how the rules work and how recent federal legislation enhances potential tax benefits, but only for transactions that occur before the end of this year.

Most of what you read about this planning opportunity will frame it as a benefit for angel investors, as well as for startups looking to close on financings by the end of this year. But some creative lawyers and accountants are noting that the rules should be able to be utilized by stock option holders, too, to the extent that they exercise options to purchase stock that otherwise meets the legal criteria.

Deciding to exercise a stock option prior to a liquidity event or when otherwise lacking a market for the relevant company’s shares is always risky. I know one guy who always exercises his options as they vest, in order to optimize the possibility he will receive capital gains treatment on liquidity or other disposition of his shares. People so inclined to make that tradeoff – paying real cash now for stock that may end up never being liquid or gaining in value – probably have every reason to strongly consider exercising any “backlog” of vesting by the end of this year, if they would otherwise be inclined to make the investment.

Even if you exercise now and even if all of the other necessary criteria are met, you don’t get the extra (or the normal) benefit of excluding gains on Qualified Small Business Stock unless you hold the stock for five years. Most of us, the koolaid we’re drinking is flavored to lead us to believe we ain’t going to be around in a deal for five years. So maybe this planning opportunity is for those who can permit themselves to contemplate that they may working a longer runway, may be in it for the long haul, or may just be doing some “downside” planning.

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