You may or may not be aware of this, but come December 31, 2013, one of the most exciting tax incentives for investing in startups is going to expire. What am I talking about? The 100% exclusion from tax for investing in qualified small business stock. This benefit expires on December 31, 2013, and it is unclear whether Congress will renew it. What I mean by this benefit expiring is, if you want to set yourself up to take advantage of this benefit down the road (you have to hold the stock for 5 years to avail yourself of the tax break), you have to acquire the qualified small business stock before the end of this year.
What does the 100% exclusion entitle you to?
Up to $10M in capital gains can be entirely excluded from tax, including the alternative minimum tax. What you generally have to do to qualify for exclusion is:
- Form or invest in a C corporation before the end of this year.
- Have that C corporation start actively conducting a business this year. (Under IRC Section 1202, stock is not treated as qualified small business stock unless, during substantially all of the taxpayer’s holding period for such stock, the corporation was engaged in an active trade or business.) What this means is it is not good enough to simply incorporate this year; the new corporation has to do business this year as well. Obtain your business licenses, open your bank accounts, and do business.
- Have that business qualify as a “qualified small business.” For example, software and Internet companies typically qualify.
For a more thorough discussion, check out my post on Section 1202.
What should you consider doing?
- If you are pondering an investment in a C corporation that you could close either this year or next year, you may want to close it this year, so that you can potentially take advantage of this tax benefit down the road.
- If you have an LLC that you have been considering converting to a C corporation, you might want to do it before year end.
- If you formed a C corporation this year, and you were thinking you made a mistake and should have been doing business as an LLC, this information may provide you with an additional reason to remain a C corporation.
Call your tax lawyer or tax accountant if you are on the fence about what to do.
By Joe Wallin and Dan Wright of Clark Nuber
Is it more complex to make a compensatory equity grant from an LLC (taxed as a partnership) than from a corporation?
Granting service providers an equity interest in an LLC is much more complex than granting an equity interest in a corporation. Here are just a few of the reasons:
- Once an employee receives equity in an LLC, the employee can no longer be considered an employee for federal income tax purposes. Instead, for federal income tax purposes, they have to be treated as “partners.” (They can still be employees for state law purposes.) This means that instead of having income and employment taxes withheld from their paychecks and receiving a Form W-2, they will instead have to make quarterly tax deposits themselves as a self-employed person, pay self-employment taxes, and receive a Form K1 from the company.
Employees who receive an equity grant in a corporation, in contrast, continue to retain employee status and receive a W-2 reporting their salary/withholding information.
W-2 reporting (v. Schedule K1 reporting) is generally easier to understand.
- Usually when a company wants to grant an equity award to a service provider, it doesn’t want the equity award recipient to owe tax upon the receipt of the award. To do this in either an LLC or a corporation, it is necessary to value the equity to be awarded (and in the corporation context grant a stock option at FMV). However, in an LLC, there is really no corollary to granting a FMV stock option. Unless the recipient of the award pays FMV for the award, it is necessary to take the additional steps to ensure that the equity award qualifies as a “profits interest.”
- A “profits interest” is defined in Rev. Proc. 93-27 and 2001-43 to mean an interest that entitles the holder to only a share of the future profits of a company. When the LLC holds assets that have appreciated before the equity grant, in order to grant a profits interest to the recipient, adjustments need to be made on the books of the LLC to reflect the pre-equity grant appreciation in the capital accounts of the existing members. This is often referred to as a “book-up”. The federal tax accounting required to “book up” the capital accounts can be complex. Frequent capital account “book-up” adjustments resulting from compensatory grants can make this difficult for the members to understand and expensive to track, especially if the value of the equity fluctuates significantly between equity grants. Corporations do not have to track capital accounts.
Suppose Moe, Larry and Curly own an LLC together. They have been working on the LLC’s business for several years. They believe the business is worth $1 Million. Moe, Larry and Curly’s capital accounts, for tax purposes, aggregate to $100,000. Their capital accounts don’t aggregate to $1M because the company has unrealized (unbooked) appreciation in its assets of $900,000. The LLC wants to grant a 10% equity interest to Noob. The fundamental question is – do Moe, Larry and Curly want to give Noob 10% of the current $1M value – a $100,000 equity award. Or do they want to give Noob a 10% share of appreciation in the business from $1M and up?
Usually Moe, Larry and Curly want to give the Noob just a share in future appreciation in the business above and beyond $1M. To do this in the LLC context, they have to book up their capital accounts to aggregate $1M. This is not necessary in the corporate context.
When favorable circumstances exist, electing to organize a business as an LLC can produce significant tax and legal advantages. However, when it comes to administering equity grants, one should carefully consider the costs and benefits of the additional tax, legal and accounting complexities associated with granting LLC equity interests. Administering a stock option and/or a restricted stock plan in a C corporation context is likely to be much simpler.
I am the founder of a company. If I formed my startup as an S corporation, can I convert it to a C corporation before the end of this year and still get 1202 status for my founder stock?
Section 1202 stock is entitled to a special tax break if held for five years. If acquired between 9/27/10 and 12/31/13 – the break is 100% (subject to a generous cap).*
No. “Qualified small business stock” means stock in a C corporation, if “at the date of issuance, such corporation is a ‘qualified small business.’” A “qualified small business” means a C corporation.
What this means is that if you initially formed your company as an S corporation and you terminate your S election before the end of this year, your founder shares will not qualify for the 1202 stock benefit (because you will have not received them when the company was a C corporation).
If you convert to a C corporation, subsequent investors may obtain the 1202 benefit, however. The reason for this? Because IRC Section 1202 (c)(1) says: “as of the date of issuance, such corporation is a qualified small business.” But shares received while the company was an S corporation cannot qualify.
The answer is different if you are currently an LLC and you incorporate. If you incorporate an LLC, your founder shares can qualify for the Section 1202 benefit.
* For more information on Section 1202 generally, please see this blog post: startuplawblog.com/section-1202-qualified-small-business-stock