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.
Congratulations, 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?
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.
Don’t rush through this process and miss an important step!