Tax Traps of Liquidity Events

Finance teams in startups and scale-ups, and the general management teams they work with and support, must walk a tightrope when considering the tax impacts of major liquidity events. “Impacts,” plural, because there are potentially several for both the business and the personal tax situations of early-stage shareholders.

Startups tend to begin with two visions. One is a vision of the impact they will have with their product or service, changing lives for the better in ways large or small. The other is of the rewards that can come to those whose ideas and companies hit it big. At VPTax we say, “Go for it!” to both visions, supporting our clients as they grow their business and its impact, and as they prepare for financial success when the business starts to grow.

Leadership teams have to keep in mind, though, the significant complexities that accompany a substantial funding round, an acquisition, and especially an Initial Public Offering. We help leaders evaluate the treatment of tax gains within the company, the impact of the transaction on founders and other shareholders, and the back-office infrastructure now required to keep up with the demand of new, external participants in what you used to think of as “your” business.

Companies feel the tax effects of transactions in different ways depending on the type of transaction—

• In an acquisition, leadership must understand the different tax impacts of a sale of the company’s stock versus the sale of some or all the company’s assets.
• Will the funds received be treated as an equity transaction within the corporation? If not, the tax character of the income may be ordinary income or capital gains.
• In addition to calculating the taxability of the transaction, there are quite often tax elections and disclosures that need to be filed with the IRS as a result.

Individual shareholders will focus on the tax impact they personally face from any transaction. They may have been targeting the benefits of the Qualified Small Business Stock exemption under IRC Section 1202, which provides for full or partial exclusion of capital gains on stock that has been held for a specific amount of time before sale.

It is at the intersection of evaluating what is best for the company and what provides the best outcome for shareholders that finance teams and tax advisors find the tightrope mentioned above. How to maximize the benefit to the company from the liquidity event, while being mindful of shareholder impact so they don’t thwart the key planning that founders have done?

An additional trap for company leaders and their finance and tax teams is the red tape and bureaucratic structure that accompanies growth and maturity. Growing quickly is fun and rewarding, and it comes with new responsibilities in many areas, including tax. Notices about funding rounds or acquisitions catch the attention of auditors so take care to consider beefing up your practices in these key areas—

• formal stock compensation administration
• sales and use tax collection and remittance
• filing necessary transaction documents
• generally anticipating economic and administrative impact of all the exciting things going on in your business

Building and growing a business is exciting and rewarding. Making it one that others also believe in and want to invest in is amazing. Being aware of the tax traps can help you keep the focus on building your rocket ship—to get you where you want to go!