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November 29, 2012

Look Before You Leap: Tax Considerations for Founders and Employees of Early Stage Companies

Much has been written about the “fiscal cliff” that, under the current tax law, awaits us after the end of this calendar year. A full discussion about the fiscal cliff is outside the scope of this article. In short, we are faced with income tax rates returning to the higher rates that were in effect prior to the initial wave of “Bush tax cuts” that began in 2001. Not only are income tax rates scheduled to change beginning in 2013, so are various estate tax provisions—either in the form of a reduced lifetime exemption or a higher transfer tax rate. In addition, there are various proposals in play that would limit the benefits of well-known estate planning strategies. In this article, we will attempt to provide you with some key action points to consider in light of the impending fiscal cliff.

Considering the exercise of your incentive stock options (ISOs)?

There are typically two primary reasons why individuals exercise their ISOs:

1. To begin the one-year holding period needed to obtain the lower tax rate on long-term capital gains; and

2. Assuming a successful exit event, the earlier ISOs are exercised, the lower the value recognized for tax purposes.

With regard to the first item, the long-term capital gain tax rate has historically been lower than the ordinary income tax rate. For example, the current capital gain tax rate is either 13 or 20 percentage points lower for the 2012 tax year, with the former amount applicable if you are subject to the alternative minimum tax. As a result, this rate differential has incentivized individuals to obtain the lower capital gain rate where available. Under current tax law, beginning in 2013, the spread may narrow to less than five percentage points, which may be enough to cause you to exercise those ISOs since the tax benefit if you wait may be much lower going forward. It is also conceivable that the preferred capital gain rate is ultimately eliminated, which would provide potentially no incentive to exercising the options early.

For those just joining a company, the price at which you would exercise typically equals the value of the underlying shares. If that’s the case, there would be no incremental tax from the exercise; your only cost would be the amount of the exercise price. If we continue to have a capital gain rate preference, it is a relative no-brainer to exercise in this situation, assuming you have the cash for the exercise price. It is important to consider the ramifications of an early exercise of ISOs not yet vested, using a Section 83(b) election to minimize ordinary income, as well as understanding what might happen if you leave the company prior to being fully vested in any exercised ISOs.

Will you have an exit event in 2012?

When a company is acquired, there is typically an escrow arrangement whereby some portion of the sales proceeds is held back for a period of time (usually 18 months). The default tax rate on the escrow proceeds is the tax rate in effect for the year you receive the escrow proceeds. This is referred to as the “installment sale” method for recognizing gain. You can actually elect out of the installment sale method and choose to be taxed on expected escrow proceeds in the year of sale, rather than year of receipt.

Why would you voluntarily pay tax on proceeds you have not yet received? Consider this:

1. If a founder has a $20 million exit event (taxed as long-term capital gains) in 2012, approximately $3 million of that may be parked in an escrow account for 18 months. If he waits to pay the tax until the year of receipt, say 2014, he may be paying a minimum federal tax rate of 23.8% (under current law), or higher depending on future tax legislation. If instead he chooses to accelerate the taxation into 2012, he would pay the current 15% tax rate for long-term capital gains. The rate differential could produce tax savings in the neighborhood of $250,000.

2. You also need to take into account the time value of money relative to paying taxes earlier than necessary. However, at the current interest rates, the opportunity cost of paying $450,000 ($3 million x 15%) a year or two earlier than necessary doesn’t make much of a dent in the $250,000 of potential tax savings.

It is important to consult your advisor regarding the ramifications of not receiving the expected amount of escrow proceeds if you elect out of the installment method.

Estate planning considerations

A common estate planning strategy for individuals with equity in an early stage company is to utilize a Grantor Retained Annuity Trust (GRAT). A GRAT usually works as follows: you contribute company shares into a trust for the benefit of your heirs and retain an annuity from the trust for some period of time. The hope is that the shares increase significantly in value after contribution to the trust. The post-contribution appreciation then passes to your beneficiaries, either outright or in trust, depending on your wishes, free of any transfer tax.

There are two common benefits of this strategy:

1. The ability to set up a GRAT for a period as short as two years. This is important because the death of the individual during the term of the GRAT causes the asset value to be included in the individual’s estate, which is the opposite of what was intended. Thus, a shorter GRAT term is viewed as desirable.

2. If structured properly, a GRAT can be successful in passing wealth to your heirs at almost no transfer tax cost (i.e., no payment of gift tax or use of the lifetime exemption)...

VC Experts
November 29, 2012
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