It’s a badge of honor for a founder to be able to say, “we started this company in my garage.” After all, notable companies like Apple started that way.
On the other hand, founders do not enjoy living in their parent’s garage. When the typical lifecycle from formation to exit for a tech company was a few short years (think 1998), such indignities could be suffered. But now that it is much more common for a tech company to take 5-10 years to sell or go public, founders are frequently looking for ways to turn some of that illiquid private company stock into cold hard cash prior to such an exit event.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]• Are folks being paid reasonable compensation even without the repurchase (leans toward purchase price)?
• Is every common holder being offered the ability to participate and the same price (leans toward purchase price) or is this a special deal for the executives (leans toward compensation)?
• Is the purchase being made by a third party (leans toward purchase price) or by the company (leans toward compensation)?
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]• The purpose for the redemption, i.e. is the company trying to sneak compensation to executives (leans toward compensation) or does an investor just really want common and can’t get it at any better price (leans toward purchase price)?
• Are folks being paid reasonable compensation even without the repurchase (leans toward purchase price)?
• Is every common holder being offered the ability to participate and the same price (leans toward purchase price) or is this a special deal for the executives (leans toward compensation)?
• Is the purchase being made by a third party (leans toward purchase price) or by the company (leans toward compensation)?
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]That said, plenty of folks argue that the entire amount paid for the stock represents purchase price, even when it looks like the buyback is occurring at a favorable price. Factors to consider include:
• The purpose for the redemption, i.e. is the company trying to sneak compensation to executives (leans toward compensation) or does an investor just really want common and can’t get it at any better price (leans toward purchase price)?
• Are folks being paid reasonable compensation even without the repurchase (leans toward purchase price)?
• Is every common holder being offered the ability to participate and the same price (leans toward purchase price) or is this a special deal for the executives (leans toward compensation)?
• Is the purchase being made by a third party (leans toward purchase price) or by the company (leans toward compensation)?
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]
That said, plenty of folks argue that the entire amount paid for the stock represents purchase price, even when it looks like the buyback is occurring at a favorable price. Factors to consider include:
• The purpose for the redemption, i.e. is the company trying to sneak compensation to executives (leans toward compensation) or does an investor just really want common and can’t get it at any better price (leans toward purchase price)?
• Are folks being paid reasonable compensation even without the repurchase (leans toward purchase price)?
• Is every common holder being offered the ability to participate and the same price (leans toward purchase price) or is this a special deal for the executives (leans toward compensation)?
• Is the purchase being made by a third party (leans toward purchase price) or by the company (leans toward compensation)?
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
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Investors understand this and are often amicable to buying founder stock or letting the company repurchase some of its own stock from its shareholders shortly after an investment round.
Here are a few things to consider with respect to these so-called midstream liquidity events. For purposes of the below, I am assuming the company is taxed as a C corporation.
Potential Compensation
For whatever reason, it is not unusual for the common stock in a midstream liquidity event to be purchased/repurchased at the preferred price. In such a case, the safest thing to do from the company’s perspective is to treat the delta as a compensatory bonus and withhold if the shareholder is (or in certain circumstances, was) an employee. This company withholding obligation can apply even if it is the investor that is purchasing the stock.
That said, plenty of folks argue that the entire amount paid for the stock represents purchase price, even when it looks like the buyback is occurring at a favorable price. Factors to consider include:
• The purpose for the redemption, i.e. is the company trying to sneak compensation to executives (leans toward compensation) or does an investor just really want common and can’t get it at any better price (leans toward purchase price)?
• Are folks being paid reasonable compensation even without the repurchase (leans toward purchase price)?
• Is every common holder being offered the ability to participate and the same price (leans toward purchase price) or is this a special deal for the executives (leans toward compensation)?
• Is the purchase being made by a third party (leans toward purchase price) or by the company (leans toward compensation)?
Regardless the facts, where the sale price is higher than whatever value a current 409A valuation would assign to the common, not treating the delta as compensation will generally create some tax underwithholding risk.
Does it create any other risk? If you want some nice reading, read the Digital Ocean law suit from 2015 where a shareholder sued the company (and WSGR and the valuation firm) for taking the position that common was worth the preferred price and then turning around and issuing options at a much lower price. The shareholder argued that either the company wasted funds by repurchasing at a price in excess of the fair market value, or granted options at a price below fair market value in violation of the equity incentive plan terms and in violation of Section 409A of the Internal Revenue Code.
One advantage of treating the delta as compensation is that the company gets a deduction. The corresponding downside is company-side employment tax.
Finally, if you do intend to treat the entire amount as purchase price, I recommend getting a 409A valuation prior to issuing options post-redemption and having the 409A valuation specifically consider the repurchase.
Qualified Small Business Stock
Qualified small business stock (QSBS) is stock received directly from a qualified small business, which can, if held for more than five years, result in 0% federal income tax on a sale.[1] Generalizing a bit, a qualified small business is a domestic C corp that is a non-service business that has never been worth more than $50M.
If the company is a qualified small business, then you’ll usually want to avoid what is considered a “significant redemption.” A significant redemption occurs when a company repurchases its own stock, other than incident to the retirement or other bona fide termination of an employee or director, and the aggregate repurchases in a rolling 2-year window (one year back and one year forward from any testing date), exceed all of:
• $10,000;
• 5% of the value of the company as of the beginning of the 2-year window; and
• 2% of the value of the company, valued as of the date of each repurchase.
The consequence of a significant redemption is that any stock issued in the 2-year window will not be QSBS.
There is also an individual test which uses a 4-year rolling window. If a repurchase violates the individual test, a 4-year black out window (2 years back, 2 years forward) applies to that stockholder, such that any stock that stockholder has received or will receive within the 4 years will not be QSBS.
One way to avoid a significant redemption is to persuade the investor to buy the common stock from the founders, rather than have the company repurchase it. On the whole however, investors prefer a company repurchase, because the investors want preferred stock, not common stock, and if an investor purchases stock from a founder, it will not be QSBS in the hands of the investor, because QSBS has to be received directly from the company.
Capital Gains vs Dividends
How will the portion that is treated as purchase price be taxed to the selling stockholder?
If the investor purchases the stock, the gain will be capital gain, long-term if the shares were held for more than one year prior to the sale.
The tax analysis is slightly more complicated if the company is repurchasing its own stock. The question is whether the amount represents capital gain or a dividend. Non-corporate shareholders would prefer it to be capital gain (because of the allowed return of basis); corporate shareholders often would prefer it to be a dividend (because of the dividends received deduction).
If the company has no accumulated or current earnings & profits (this is defined under accounting rules) as of December 31 of the year of the repurchase, then just like above, the purchase price will be capital gain, long-term if the shares were held for more than one year prior to the sale.
If the company does have earnings & profits, then the repurchase price can be a dividend to the extent of the earnings & profits, unless certain other tests are met, which can trump dividend treatment.
For example, capital gain will win the day if the stockholder suffered a 20% reduction in percentage ownership when considering all of the repurchases, including possibly, some that occur later in the year. Rev. Rul. 75-447, holds that if the redemptions are done in connection with a financing, that you view all events together, to determine if a >20% reduction occurred. Thus, you can view the pre-financing percentage vs. the post-financing percentage.
Given the multiple tax considerations that come into play with respect to midstream liquidity events, I generally recommend that both the company and significant stockholders consult tax advisors.
Mike Baker frequently advises with respect to the tax consequences of midstream liquidity events. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Higher rates apply to stock issued prior to September 28, 2010. Also, for the favorable QSBS rates to apply, in addition to avoiding significant redemptions, the company must run an active business during substantially all of the stockholder’s holding period.
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