Originally published by Law360
Founders who plan to sell their company invariably ask their tax advisers about the possibility of reducing the tax cost of the sale. When they do, founders invariably learn that a lot of factors affect the amount of tax they must pay, and when they must pay it.
Federal Income Tax
A founder is generally required to include in income the
consideration received for the interests in the company, reduced by
the founder's tax basis in the interests, unless the sale
qualifies for tax-free treatment. Consideration generally consists
of cash and property paid to the founder, and any liabilities from
which the founder is relieved.
The highest marginal federal tax rate on ordinary income (OI) is
39.6 percent. By contrast, the highest marginal federal income tax
on long-term capital gain (LTCG) is 20 percent (subject to the
additional 3.8 percent net investment income tax, discussed below).
To qualify for the LTCG rate, the founder must hold the interests
for more than one year, and for investment. If the interests are
held for a year or less, the gain is subject to tax at short-term
capital gain rates, which are generally the same as OI tax rates.
Founders must pay careful attention both on receipt of the
interests and on the disposition of the interests in order to
maximize the LTCG treatment.
Founders should also be aware of the possibility that interests in
a C corporation (or limited liability company taxed as a C
corporation) may qualify for special preferential treatment if
those interests are "qualified small business stock"
within the meaning of Section 1202 of the Internal Revenue Code of
1986, as amended (Code).
Receipt of the Interests
A founder typically receives interests in the company either in
exchange for services, or in exchange for a contribution of cash
and/or property to the company. If interests are received in
exchange for a contribution of cash or property, the founder
generally would not have any taxable gain on the receipt of the
interests, the founder's tax basis in the interests would equal
the amount of the cash or the founder's tax basis in the
property contributed to the company, and the founder's holding
period for the interests received would generally include the
holding period of the property exchanged for the interests. (A
founder's tax basis in the company interests would be affected
by any liabilities assumed by the company in connection with the
contribution of property.)
In case of interests received in exchange for services, tax
treatment depends on whether the interests are vested or unvested.
In addition, special rules apply to profits interests issued by a
partnership (or by a limited liability company taxed as a
partnership) for services. Vested interests are generally included
in the founder's income and taxed at OI rates at the time of
receipt. Unvested interests are generally taxed at OI rates at the
time when they vest. When the interests are included in income at
OI rates, the founder receives a tax basis in the interests equal
to their value. The founder's tax basis would also include the
amount, if any, paid by the founder for the interest. Any gain or
loss recognized when the interests are sold is generally treated as
capital gain, or capital loss.
A founder can generally elect under Code Section 83(b) to include
unvested interests in income when they are granted. If the election
is made, the founder pays tax at OI rates at the time of receipt,
and there are no tax consequences when the interests vest. Any
increase or decrease in value between the time when the interests
are included in income, and the time when the interests are sold,
is generally treated as capital gain (or capital loss) for income
tax purposes. Founders typically choose to make the election,
especially if the value of the unvested interests on the date of
the grant is relatively low, because founders expect unvested
interests to increase in price. However, if the interests are
forfeited prior to vesting, the founder would only be able to claim
a capital loss deduction for any amounts paid by the founder for
the interests. Also, founders should keep in mind that if the
interests are subsequently sold at a loss, the loss would be a
capital loss. Subject to a minor exception capital losses do not
shelter ordinary income, e.g., salary.
Sale of the Interests
In order to qualify for LTCG treatment, exit consideration must be paid in exchange for an investment asset held for more than one year. That is not the case if consideration is paid for something other than the founder's interests in the company. For example, Brinkley v. Commissioner, No. 15-60144, 2015 TNT 242-13 (5th Cir. Dec. 16, 2015) illustrates that consideration paid to induce a founder to sign an employment letter with the acquirer is taxed as ordinary income.
Also, even consideration paid for company interests that are held for more than a year can be taxed at OI rates to a certain extent. If the company is a partnership (or a limited liability company taxed as a disregarded entity or a partnership), any gain inherent in OI assets, which generally include unrealized receivables, inventory, and assets that have been previously amortized or depreciated, would be taxed at OI rates. Similarly, if the company is taxed as an S corporation and an election is made under Code Sections 338(h)(10) or 336(e) to treat the stock sale as an asset sale for tax purposes, any gain allocated to OI assets would be taxed at OI rates.
Federal Net Investment Income Tax
A founder's taxable sale proceeds may be subject to the net investment income tax (NIIT) at a rate of 3.8 percent. Gain from sales of interests in a C corporation is generally subject to the NIIT. Gains from sales of interests in other entities are generally exempt from the NIIT to the extent that the company is engaged in active, nontrading business and the founder is active in that business.
Tax-Free Transactions
In certain instances, interests in the acquiring entity (or in the acquiring entity's parent entity) that are issued by the entity in exchange for the founder's interests in the company are subject to tax-free treatment. Accordingly, if consideration consists in whole or in part of interests in the acquiring entity or its parent entity, founders should inquire into the applicability of tax-free treatment. This is true even if the founder wants the sale to be taxable, because in that case it would be important to make sure that tax-free treatment does not apply.
Cross-Border Context
If a founder receives interests in a foreign entity in exchange for some or all of the interests in the company, the founder must pay special attention to the international tax rules. Where relevant, the founder may be required to comply with additional requirements in order to qualify the transaction for tax-free treatment. Also, the founder may be required to comply with certain reporting requirements, and may be subject to additional U.S. income taxes as a result of owning interests in a foreign entity. Finally, the founder should understand the tax laws of the jurisdictions in which the foreign entity is formed and does business.
Timing Considerations
A founder may be able to defer the recognition of a portion of the gain by reporting the transaction under the installment method, if a portion of the consideration is received in the year (or years) after the sale of the company. Although frequently beneficial, installment method reporting comes with a certain amount of tax cost: The founder may be deemed to have imputed interest income, unless the buyer pays actual interest on the deferred consideration, and, in certain circumstances involving a significant amount of deferred consideration, the founder may be required to pay an interest charge.
Walsh Sales/Related-Party Rules
If a founder wants to sell loss assets to shelter (some of) the capital gains from the sale of the interests, it is important to pay careful attention to the wash sale rules and the related-party rules to make sure the loss would be allowed.
State and Local Tax Considerations
If a founder's local jurisdiction has high state and local income taxes, e.g., New York City, the founder may consider moving to a state or local jurisdiction with lower or no income taxes, prior to the sale. This tax planning technique may be difficult to effect, depending on the circumstances, including the founder's desire to indefinitely relocate to another jurisdiction.
Estate Planning Considerations
A founder's heirs would generally get a step-up in tax basis of the company interests when the founder passes away. This means that the heirs' tax basis in the company interests would equal the fair market value of the interests (generally at the date of the founder's death), and the heirs would not recognize any gain if they sell the interests for that amount. Accordingly, in some cases, a founder may wish to retain the interests in the company and let the heirs sell the interests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
