The tax code is designed to encourage innovation, but only if you know where to look. For founders seeking to maximize the value of their startup exit strategy, here are some tips that can help create a plan that saves you money while being compliant with IRS rules.
Types of exit strategies for startups
There are, broadly speaking, three different types of exits. The first is a financial strategic exit, in which the founder sells her or his company to another company or a private equity firm. A fire sale is when you exit the company because it isn’t working, and sells the business at a heavily discounted rate. And finally, the worst-case scenario — the founder has to shut down with no sale, and simply discontinues operations.
The exit strategy you use will impact your approach to investing, reinvesting, and structuring your accounts for the best possible tax return. For instance, founders who accomplish a strategic exit and sell their business will need to consider how to minimize capital gains tax.
If you’re not sure where to start, use Valur’s solutions to find the best possible options for your specific exit. They have strategies built around the advantages the tax code offers, no matter your circumstances. And, by using their planning tools, founders can earn additional returns of 50% or more. Here are a few tips to consider when planning your startup exit strategy.
Go for long-term capital gains
The tax you pay on capital gains depends on how long you hold the investment before selling it. Capital gains are classified as either short or long-term and taxed at different rates accordingly. Short-term gains tax is the same rate that you would pay on your ordinary income. Depending on your federal tax bracket, that can be up to 37% in 2021 (not including potential additional state taxes).
Long-term capital gains tax applies to assets that have been held for more than one year. The tax rate is according to graduated thresholds for taxable income: 0%, 15%, or 20%. Most taxpayers who report long-term capital gains don’t pay more than 15%.
Ideally, plan your exit for at least a year after you received the shares to avoid triggering the higher short-term capital gains tax rate.
Borrow using private banks
If you’re in need of liquidity, you can look to borrow from a private bank instead of selling your stake in the company. This approach will allow you to avoid triggering any capital gains tax. Compared to capital gains taxes, this can be a much better option.
Likewise, if you are close to a year holding period — but need money now — it can make sense to hold selling your stake in the company until you have reached the long term capital gains tax rate holding period. You might be able to borrow from a private bank until you have held your stake in the company for a year to reach the lower long-term capital gains tax rate.
Set up a charitable remainder trust
Set up a charitable remainder trust
A charitable remainder trust (CRT) is a tax-exempt irrevocable trust that can reduce your taxable income. These trusts critically allow you to avoid paying taxes when you sell an asset which can offer significant financial benefits for highly appreciated assets such as your startup equity, crypto or public stocks. These CRT’s then allow beneficiaries such as yourself to draw a certain amount of income each year from the trust for a period of years or for your life or multiple lifetimes and then donate any funds that remain in the trust to your chosen charity.
Invest in opportunity zones
An opportunity zone is a geographic area designated by the IRS and used as an economic development tool to invest in distressed parts of the US. The IRS’ goal of using opportunity zones is to “spur economic growth and job creation in low-income communities while providing tax benefits to investors.”
As a result, the IRS makes it attractive for entrepreneurs and startup founders to reinvest money from their sale into opportunity zones. Opportunity zones could be an effective way to defer capital gains tax. By investing the money you earn from selling your stake in a Qualified Opportunity Fund (QOF), it’s possible to avoid paying capital gains tax until you sell or exchange your QOF investment or until Dec 31, 2026, whichever is earlier. Likewise, holding an investment in a QOF comes with additional tax benefits:
- If the investor holds the QOF investment for at least 5 years, the basis of the QOF investment increases by 10% of the deferred gain.
- If the investor holds the QOF investment for at least 7 years, the basis of the QOF investment increases to 15% of the deferred gain.
- If the investor holds the investment in the QOF for at least 10 years, the investor is eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged.
Opportunity zones are a good way to exit your startup without high taxes, as well as to invest in communities in need.
Use charitable deductions
The IRS allows for up to 50% of adjusted gross income to be deducted for charitable donations. Founders can write off realized gains from past sales by taking charitable deductions to lower their income. By creating a charitable remainder trust or charitable lead annuity trust, founders are able to keep the capital to invest by promising to donate the assets at a later date.
Alternatively, consider directly donating the proceeds from selling your stake in a startup to a Donor Advised Fund. When an appreciated asset is donated, the asset’s fair market value is the amount used to reduce taxable income. In addition, if the organization is a qualified charitable organization, you won’t pay capital gains tax.
Take advantage of the QSBS Exemption
QSBS stands for Qualified Small Business Stock. These are shares of a qualified small business that is an active, US-based C corporation whose gross assets do not exceed $50 million on and immediately after its stock issuance. The QSBS rule allows some owners of startup equity to eliminate 100% of the taxes—state and federal—on the greater of their first $10m of gains per asset or 10x the cost basis of an asset.
Using the Qualified Small Business Stock (QSBS) Exemption, you can pay 0% federal and state taxes on most of your startup equity if you have held it for five years. And, moreover, you can even multiply that protection by gifting equity to a Charitable Remainder Trust—meaning the tax exemption is potentially unlimited.
With the right planning, you can make the QSBS work for you. See if you can hold for five years to take advantage of the tax exemption. Or, if your shares are eligible for the QSBS exemption, but you won’t be able to hold your shares for another five years, consider investing some of your proceeds into another QSBS startup so those returns have the opportunity to become eligible for the QSBS exemption.
The QSBS exemption is one of the most compelling options for founders seeking to optimize their startup exit strategy. If you’ve already used up your full QSBS exemption, consider gifting additional shares to loved ones or eligible trusts that can claim their own QSBS exemption to avoid taxes. It’s one of the most effective ways to protect your gains from high capital gains tax rates.
Invest in a Roth IRA
A Roth IRA is an investment vehicle that allows qualified withdrawals on a tax-free basis if certain conditions are satisfied. Because Roth IRAs are funded with after-tax dollars, the contributions are not tax-deductible. But, as soon as you start withdrawing funds, this money is tax-free. If you plan ahead, this means you can invest in a new business or startup using funds from a Roth IRA account — making any returns you receive upon exit tax exempt.
There is a limit as to who is eligible to contribute to a Roth IRA. If you earn over a certain threshold, you are not allowed to add to a Roth IRA. The 2022 limit for single individuals is $144,000; for married couples filing jointly, the limit is $214,000.
Understand your equity structure
Simply put, each type of equity grant can have a different tax treatment. There are four main types of shares a startup might offer:
- ISOs: Incentive stock options. These equities are subject to extensive restrictions. “ISOs can only be issued to employees, and the company issuing the ISO cannot take a tax deduction,” wrote one wealth advisory firm.
- NSOs: Non-qualified stock options. Employees who receive an NSO will have to pay ordinary income taxes on the spread (the difference between the grant price and market price).
- RSAs: Restricted stock awards. “Unless an 83b election is timely filed, the fair market value of the stock on the vest date, or the date when the employee has no substantial risk of forfeiture, is considered taxable compensation income,” wrote the firm.
- RSUs: Restricted stock units. These equities are not granted to the employee until certain conditions are met. However, income taxes apply to RSUs — meaning that employees lose the chance to potentially be taxed at a lower capital gains tax rate.
For those with RSA and RSU equities, an 83(b) election is an IRC that gives a startup founder the option to pay taxes on the total fair market value of a restricted stock at the time of granting. As you plan your exit strategy, confirm past 83(b) elections, as these will impact the cost basis of your equities — and ultimately your tax liabilities.
RSUs present a potential sticking point, too. RSUs are taxed differently than other kinds of stock options, as the entire amount of the vested stock must be counted as ordinary income in the year of vesting. This presents a “double-trigger” scenario, in that two events are required before a founder owns the share. “The amount that must be declared is determined by subtracting the original purchase or exercise price of the stock (which may be zero) from the fair market value of the stock as of the date that the stock becomes fully vested,” explained Investopedia.
As part of your startup exit strategy, confirm if your RSU is fully vested and whether or not it can be taxed at a lower capital gains tax rate.
Prepare for a lockup period
For founders and employees seeking to exit after a successful IPO, be aware that you may be subject to a lockup period. A lockup period is a designated time period during which major shareholders are prohibited from selling their shares. Lockup periods typically last for 90 to 180 days. If you’re seeking to plan your exit strategy, keep this lockup window in mind. Depending on your role in the company, you may have to wait to divest your shares.
Research a 10b5-1 plan
Finally, depending on your role in the company and the exit, you may consider a 10b5-1 plan. Rule 10b5-1 was established by the SEC to allow insiders at publicly-traded corporations to set up a trading plan for selling stocks they own. Essentially, this rule would allow you as a startup founder to participate in trading without violating insider trading rules.
Note that at the end of 2021, the SEC announced proposed changes to the rule which would greatly increase disclosure requirements for such trades and require the person setting up the trades to “certify that they are not aware of material nonpublic information.”
For more tips to help you create the best startup exit strategy, check out Valur’s Founders Guide with tons of resources on setting up charitable remainder trusts and more.
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