This (Hypothetical) Founder Saved $3 Million In Federal Taxes

Editor's note: Alex Katz is a partner and CFO with ff Venture Capital, an institutional investor in seed-stage companies.  

Many venture-capital firms and other investors insist on investing only in corporations in order to avoid the complications that may flow from an investment in an LLC. As a result, many founders choose, or are advised by their attorneys or accountants to choose, to start their businesses as corporations, well before the receipt of VC funding. In so doing, they are giving up what could be a substantial tax opportunity.

I have written before about the tax benefit to investors from investing in a Qualified Small Business (QSB). The fact sometimes gets lost, but a company founder is also eligible for the tax benefit of excluding a portion of his QSB gain when he sells his interest. (State and local tax rates vary.) Because the law places limits on the tax benefit, careful planning by a founder is required.

The Internal Revenue Code allows a taxpayer to exclude from his or her income the greater of $10 million or 10 times the taxpayer's basis in the stock sold [Internal Revenue Code section 1202(b)(1)]. Let's focus on the "10 times the taxpayer's basis" part of the limitation. The tax code also says that in the case where the taxpayer transfers property (other than money or stock) to a corporation in exchange for stock in such corporation, the basis of the QSB stock in the hands of the taxpayer shall equal the fair market value of the property transferred [Internal Revenue Code section 1202(i)(1)].

First some assumptions:

• A typical founder who bootstraps her business will invest in her company only as much as she can get from maxing out her credit cards or from borrowing from friends and family. Let's assume that comes to $20,000.  Let's call this her "basis" in her interest.
• One year later, the company issues Series Seed Preferred shares at a $2.5 million pre-money valuation. In other words, the investors believe that the company has a fair market value of $2.5 million at the time they invest.
• Seven years after that, the company goes public with a market cap of $250 million, and the founder owns 10 percent of the company at that time. Note this is above the typical range of a founding CEO's ownership at IPO, although this figure ranges dramatically from de minimis to much more than 10 percent.

If the founder starts her business as a corporation, her basis for calculating the QSB gain she can exclude would be $20,000. And when she later sells her shares after the post-IPO lock-up period has expired, the maximum gain she could exclude would be $10 million (the greater of $10 million or 10 times $20,000). Her federal tax bill under rates now in effect would be $2,996,000. Instead, if she started her business as an LLC and converted to a corporation at the time her company issued the Series Seed shares, her basis for calculating the QSB gain she can exclude would be $2.5 million, and she could therefore exclude up to $25 million (10 times her basis). Under these facts, her federal tax bill would be zero.

Simply by reading this blog post, she would have saved almost $3 million in federal taxes.

Taxation of LLCs can be very complicated. For example, the IRS issued regulations on February 4, 2013, that provide that a holder of a "Non-Compensatory Option" in a partnership (or an LLC taxed as a partnership) may be treated as a partner (or a member in the case of an LLC) in certain cases, even if none of the parties ever intended this treatment. A Non-Compensatory Option includes an option (other than an option issued in connection with services), a warrant or even convertible debt. This could make the LLC's tax situation far more complex than expected, especially if the LLC ignored John Frankel's advice and issued convertible notes as an LLC before it converted to a corporation and issued preferred stock.

———

This information is offered by ff Venture Capital as a general description of the subject matter presented, and is not intended to provide an exhaustive analysis of applicable Federal, state or local tax laws. The reader has to seek advice from his or her own tax adviser, based upon the specifics of his or her own tax and financial situation. To ensure compliance with requirements imposed by the IRS, ff Venture Capital informs you that any U.S. Federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.