Tax Free Founder Stock

If you are thinking about starting an early stage tech company, one of the first things you will have to figure out is what type of legal entity to form.

Fortunately, there are only a few choices available to you. Your choices are basically only 1 of the following 3 possibilities:

• an LLC taxed as a partnership for federal income tax purposes
• a corporation that has made an election to be taxed as an S corporation for federal income tax purposes, or
• a C corporation

Entity Choices

LLCs Taxed as Partnerships. An LLC taxed as a partnership is a state law limited liability company that has multiple members that has not made an election to be taxed as a corporation. An LLC taxed as a partnership does not pay federal income tax. Intead, it’s owners pay the income tax on the LLC’s income. The LLC files an information return with the IRS each year and sends each owner a Form K-1, so that the owners know what income they owe tax on. If the LLC incurs losses, sometimes the owners can deduct those losses on their tax returns.

S Corporation. S corporations are like LLCs in that they are pass through companies–meaning, an S corporation does not pay federal income tax; its owners pay the tax on the entity’s income. The entity files an information return with the IRS and sends each stockholder a Form K-1 each year so that the stockholders can pay the tax on the entity’s income. S corporations are only available if all of the stockholders are individuals (generally) and US citizens or lawful permanent residents (VC funds can’t be S corporation stockholders). Again, if the entity loses money, sometimes the stockholders can deduct those losses on their tax returns.

C Corporation. A C corporation pays its own taxes. Its stockholders do not pay tax on the entity’s income. If the C corporation pays dividends to its stockholders, the stockholders pay tax on the dividends. Thus, if a corporation is profitable, it will pay federal income taxes. Then when it pays dividends to its stockholders, the stockholders will pay tax on the dividends. This is sometimes referred to as the double tax problem.

The Importance of the Choice of Entity

Your choice of entity is important because it affects important immediate and downstream consequences, including:

• How much money it will cost you and your co-founders to set up the company.
• Whether the entity will be an entity that is easy to use to do important things like (i) grant stock options to advisors and service providers, and (ii) raise money from angels and venture capitalists.
• How the founders will be taxed on the ultimate sale of the company, or their ultimate sale of their stock.

In general, LLCs taxed as partnerships are lousy choices for an early stage tech company that wants to follow the traditional path of granting stock options and raising money from Angels and VCs. Granting the equivalent of stock options in an LLC is complex and costly from a legal and accounting fees perspective.

That leaves you with the choice of S corporation or C corporation. Most angel investors do not want to invest in pass through companies and receive a Form K-1 from a company they invested in. This rules out S corporations.

Thus, you are left with a C corporation as the default best choice if you want to follow the traditional path.

But what if you desire to be able to take the losses from the company on your personal income tax return? Shouldn’t you form an S corporation then, and stay an S until you take money from investors?

The answer depends. But if you choose anything other than a C corporation you are potentially walking away from a very important tax benefit available to founders.

Tax Free Founder Stock

Under the federal income tax law, if you acquire stock in a C corporation with less than $50M in gross assets (both before and after you acquire your stock), and the corporation is engaged in a qualified trade or business (see definitions below) and observes some other rules–if you sell that stock after holding it for 5 years, up to $10M in gain can be completely excluded from federal income tax.

This exclusion doesn’t work if you form an S corporation or an LLC taxed as a partnership.

Below you will find the defined terms used in Section 1202 of the Internal Revenue Code. Don’t overlook this potentially very significant tax benefit when you decide on your choice of entity.

Keep this in mind when choosing what type of entity to form. If you qualify, you don’t to inadvertently miss this potential benefit.

Section 1202 Definitions

“Aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation.

“Eligible corporation” means any domestic corporation; except that such term shall not include—
(A) a DISC or former DISC,
(B) a corporation with respect to which an election under section 936 is in effect or which has a direct or indirect subsidiary with respect to which such an election is in effect,
(C) a regulated investment company, real estate investment trust, or REMIC, and
(D) a cooperative.

“Eligible gain” means any gain from the sale or exchange of qualified small business stock held for more than 5 years.

“Parent-subsidiary controlled group” means any controlled group of corporations as defined in section 1563(a)(1), except that—
(i) “more than 50 percent” shall be substituted for “at least 80 percent” each place it appears in section 1563(a)(1), and
(ii) section 1563(a)(4) shall not apply.

“Pass-thru entity” means—
(A) any partnership,
(B) any S corporation,
(C) any regulated investment company, and
(D) any common trust fund.

“Qualified small business” means any domestic corporation which is a C corporation if—
(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

“Specialized small business investment company” means any eligible corporation (as defined in subsection (e)(4)) which is licensed to operate under section 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993).

This blog post does not constitute legal or tax advice. Always consult a legal or tax professional with your tax questions.