For many venture companies, the goal is clear — start the business, raise private equity and grow the business, and then access the public equity markets. In the last stage, the initial public offering (IPO) is often combined with a liquidity event for the founders, investors and employees. Here are some of the tax issues that are involved in planning for the IPO.
The Existing Entity
There are three basic entity choices for the start-up business: a "C" corporation, an "S" corporation or an LLC/partnership. Almost all publicly held entities are C corporations — they cannot be S corporations because they will have more than 75 shareholders. An LLC can be publicly traded, but taking an LLC public is usually not desirable from the underwriters’ perspective, so an LLC would need to convert to a corporation prior to the IPO. Conversion of either an S corporation or an LLC can raise tax concerns.
Taking the S Corporation Public
If the business is an S corporation until the IPO, the S election will terminate on the day of the IPO, and the corporation’s last tax year as an S corporation will end on the day prior to the IPO. The planning for the termination is similar to that which would occur if the S corporation status were terminated on the issuance of preferred stock to investors in the pre-IPO stage. The key elements are:
1. Allocating Income or Loss. The termination of the S status will result in two tax years — the short S year that ends on the day prior to the IPO and the new, short C year that begins on the day of the IPO. The S share-holders may generally elect to "close the books" on the day before the IPO to calculate the income and expenses attributable to each period. If no election is made, the income and expenses will be allocated ratably, on a daily basis. The choice can be a negotiated item with the underwriters.
2. Distributions. At a minimum, the S shareholders will generally look for distributions to cover their taxes attributable to the S corporation income for the period prior to the S termination. The S shareholders may also negotiate for a distribution to cover previously taxed S corporation income, which may be received by them tax-free.
3. Tax Agreement. Commonly, an agreement between the S share-holders and the corporation would be developed to handle preparation of final S returns, final tax distributions and management of S audits, including allocation of risks on timing and permanent differences.
Incorporating a Partnership or LLC
While the conversion of an S corporation to a C corporation occurs by operation of law on the day of the IPO, converting an LLC to a corporation requires independent affirmative action. If the conversion involves removing assets from the LLC in anticipation of the IPO, the tax consequences can be complex. If the conversion does not involve any special tailoring of assets, it is generally a tax-free event, subject to two key exceptions:
1. If the conversion is part of the IPO, after the IPO the former members of the LLC and the public that acquired stock from the corporation in the IPO must own at least 80% of the voting stock and 80% of each class of non-voting stock of the corporation. If that control test is not met, all members of the LLC will have a taxable event as a result of the conversion. The problem generally arises when the shares issued in the IPO do not represent a large percentage of the corporation and there are significant secondary sales by the founders/investors.
2. To the extent the LLC has liabilities that exceed its basis in its assets, the conversion will generally result in taxable income to the LLC members. This comes into play most frequently in start-up companies that expense, rather than capitalize, their pre-IPO activities. Whether there will be a tax liability to the members will depend on other income and expenses earned in the LLC during the year of conversion and past years.
Similar to the conversion of an S corporation, members of an LLC should consider negotiating a tax agreement for the conversion.
PLANNING FOR EQUITY HOLDERS AND EMPLOYEES
Two of the principal areas of planning for equity and option holders involve obtaining liquidity for existing positions and transferring stock or options as gifts or charitable contributions. As noted below, from a tax perspective, timing is everything in this area.
Option Holders Selling in Over-Allotment
An option holder who is contemplating agreeing to sell shares in an over-allotment needs to be wary. The concerns are best illustrated by example: An employee receives non-qualified stock options to acquire 100 shares of the corporation at an exercise price of $15 a share, the anticipated IPO price. If she exercises the options on a day that the value of the stock is $15 per share, she has no income and a $15-per-share basis. If she delivered some of these shares for sale in the over-allotment and receives $15 per share, she has no gain on the sale.
What if she holds the options 30 days and is called on to deliver shares under the over-allotment option, and the stock is then trading at $75 per share? She would have $60 a share in compensation income, taking a basis of $75 per share. She then sells the stock in the over-allotment for $15 and realizes a capital loss of $60. If that is her only taxable event for the year, she owes tax on the compensation income because the capital loss cannot offset ordinary income.
Gifts of Stock
If a gift is made of closely held stock, rather than publicly traded stock, there is considerably more flexibility in valuing it. However, if gifts are made after the underwriting commitment or after a decision is made by the board of directors to go public, the value will be higher than if the possibility of an IPO did not exist. It may, however, still be a fairly substantial discount from the IPO price.
Gifts of Options
The transfer of a non-qualified stock option (NSO) is treated as a completed gift only if the option has vested, and it is the value on the date of the completed gift that determines the amount of the gift. Notwithstanding that a completed gift has occurred, when the option is exercised by the donee, the donor has compensation income equal to the difference in the exercise since and the value of stock when the option is exercised.
Sale by Donee in Secondary Offering
If a holder of stock in a company that undergoes an IPO makes a gift of stock shortly before the IPO and the donee sells the stock in the secondary offering, the question of whether the donor or donee pays the tax on the sale can arise under the anticipatory assignment of income doctrine. If the gift were made to a family member, it is unlikely that there would be any significant rate difference between the donor and donee’s rates unless there was very little gain and the donee had little other income. If the stock were given to a charity, however, part of the incentive for the gift is that a charity pays no tax at all on its capital gains.
There is no clear line of demarcation for when a gift to charity can be made in such circum-stances. If one could conclude that the stock was "practically certain" to be sold in a secondary offering, it may be too late for a stockholder to make a charitable gift of the stock and have the sales proceeds taxed to charity.
Planning for the tax consequences of the IPO should begin long before the event occurs. It starts with the initial choice of entity for the business, and should include employee compensation planning and estate planning. As is often the case, timing is important in the implementation of the plans.
CAPITAL GROWTH INTERACTIVE ® 2002 VENTURE GUIDE WWW.CAPITALGROWTH.COM
Joan C. Arnold
