All posts in Equity Compensation

The Unbearable Lightness (of Being an LLC)

LLC Stock OptionsI had a client press me recently about converting from an LLC (taxed as a partnership) to a corporation.  The client had been considering raising money from angels and wanted to grant traditional corporate-style stock option to employees.

I suggested that if he wanted to raise money from third parties (whether angels or venture funds) and grant traditional stock options to employees and service providers, that it would probably make sense for him to convert to a C corporation.

“Most investors don’t want to invest in a pass through company. Either an LLC or an S corporation,” I told him. “They don’t want to receive a Form K-1.  Plus, stock option style equity grants in an LLC are not easy; they require book ups and complex capital account maintenance accounting.”

He and his co-founder changed their minds about raising angel money. The client didn’t think they needed or wanted to raise money from third parties, but still wanted to give employees traditional equity incentives. Their concern was, if they converted to a C corporation and decided to sell down the road, the future buyer might only want to buy the company’s assets and not the stock – thereby giving rise to the dreaded double tax.

“It is possible that if you convert your LLC to a C corporation that you could spend several years growing the business, and then have a buyer demand to buy the assets and not the stock,” I said. “If that happened and you went ahead and had the C corporation sell the assets, there would be a corporate level of tax owed that you would have avoided had you remained an LLC.”

“However,” I added, “there are still a number of good reasons to be a C corporation, and the likelihood of what you described happening is, in my experience, not common. You see, most ‘up’ deals are stock deals, or structured one layer of tax transactions, such as reverse triangular mergers.”

The client remained uncertain. I couldn’t tell the him that what they were afraid of was out of the realm of possibility, because frankly, it was a possibility. I have seen it happen on a few occasions in my career (granted, it’s been a long time).  On at least one occasion in the past, a C corporation received an acquisition offer on its assets.  The buyer wouldn’t budge on its demand to buy assets and not stock. In that case, due to the adverse tax consequences, the C corporation had to pass on the deal.

“Well, we want to remain an LLC then,” the client said.

“OK,” I said “but keep in mind that if in several years an acquiror company wants to acquire your company in an all stock transaction, you won’t be able to defer your gain on a stock deal until you sell the stock.”

“What do you mean?”

“Well, it is not uncommon for some acquirors, especially public company acquirors, to purchase other companies in all stock or mostly stock transactions.  Meaning, your stockholders will receive a portion of the deal (at least 40%) in stock, which might not be liquid.  In that case, they won’t be able to sell it for some time.  But if you are an LLC, such an acquisition could not qualify as a ‘reorg’ under the tax law, thus you would be taxed on the stock as if you received cash and turned around and bought the stock.”

“That sucks,” he said.

“I know,” I replied.

“What do I do?”

He wanted me to make the decision for him; to end his agonizing over the decision. I couldn’t do it.  It was his business; his decision.

“If I just stick as an LLC,” he said, “just how bad will it be again?”

“Well,” I said, “you will have to worry about book ups, and capital account maintenance, and a complex LLC agreement. But there are worse things that could happen to you than spending quality time with your tax lawyers and tax accountants. Just enjoy.”

“Plus,” I added, “if you remain an LLC you will not have to worry about a double level tax on sale of the LLC and you can always convert to a C corporation later.”

Conclusion

Choice of entity is not always easy.  Sometimes it is agonizing.

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Going, Going, Gone: Qualified Small Business Stock

QSBS

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.

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Stock Option Exercise Checklist

Stock Option Exercise ChecklistCongratulations, you’ve gotten your company off the ground.  You’ve incorporated, issued founder shares and filed 83(b) elections, adopted a stock option plan, granted stock options, and been working on your business for a while.  Now an employee who has been with you since the start wants to exercise a stock option that has vested in part.  What do you do?

Recommended Steps

I recommend that you take the following steps as you process each option exercise:

  • Review the stock option exercise notice; confirm that it is completed correctly and executed by optionee.
  • Make sure that you have all of the optionee’s original stock option paperwork signed and in the files (meaning, the notice of grant of stock option or stock option agreement).
  • Confirm that option was approved by the Board in minutes and/or a Board consent.
  • Confirm that your Rule 701 math was correct, and that you are operating within Rule 701′s limitations and conditions.
  • Was the optionee terminated and in connection therewith did the optionee execute a release of all claims?  If so, did the release terminate the stock option?
  • Confirm the tax status of the option being exercised—nonqualified stock option (NQO) or statutory (incentive) stock options (ISO)?  Is it in part an ISO and in part an NQO?
  • Make sure the optionee is only exercising with respect to vested options or options that are not vested but immediately exercisable.
  • Confirm Blue Sky securities law compliance. (In which state does the optionee reside? Are securities filings required?)
  • Does the Company have a repurchase option with respect to the shares?  Will the Company exercise its repurchase option?
  • Determine whether the Board of Directors needs to make a new determination of the fair market value of the shares to determine the tax withholding or ISO adjustment amount.
  • Calculate the tax withholding (including but not limited to federal income and federal employment) if the option is an NQO (if the option is an ISO, make sure employee understands AMT tax consequences and be sure to send notification of ISO gain to employee and IRS).
  • Make sure to obtain from the exercising optionee the strike price plus the tax withholding, if tax withholding is required.
  • Consider providing the optionee with disclosure of some of the material risks of buying the securities.  A bullet point list of risk factors, financial statements, for example.
  • Have Company counsel prepare a stock certificate and stock certificate receipt.
  • Update the Company’s capitalization table.
  • Make sure payroll is aware of the exercise and properly reports the exercise on wage statements/Forms W-2, or ISO adjustment notification.

Conclusion

Don’t rush through this process and miss an important step!

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