By Harness WealthTaxes — April 10, 2020

Tax Planning for When Your Startup is Acquired

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Founders, board members, and employees of startups that get acquired can experience tax consequences as a result of a liquidity event. It’s imperative to plan for the tax implications so you can be prepared to pay what you owe the IRS. And in some cases, you may be able to take steps to reduce the taxes that result from the acquisition, depending on the type of equity you have and the nature of the transaction. 

Three types of startup acquisitions and their tax consequences

There are three primary ways an acquisition could take place:

  1. All-cash acquisition: Under these circumstances, stock shares and options are typically cashed out. Equity is converted to cash and you’ll pay either long-term or short-term capital gains taxes depending on how long you owned shares. 
  2. All-stock acquisition: When this type of transaction takes place, stockholders with vested shares (and sometimes vested and unvested options) of the acquired company will receive stock shares of the new company or option grants for the new company. In some cases, the old cost basis of your stock remains as the new cost basis for your newly acquired shares in the acquiring company.  When your shares are converted, this may be a taxable event. 
  3. Cash and stock acquisition: In a blended deal, some shares and options are cashed out and others are converted to shares or option grants of the acquiring company.  Often, there are immediate tax consequences when shares are cashed out and long-term tax consequences after shares of the old company are converted to shares of the new company.

Typically, all-stock acquisitions and cash/stock acquisitions can create more complicated tax consequences than all cash acquisitions. Stockholders will also have more choices surrounding when to exercise options and when to sell stock shares in both all-stock transactions or stock/cash acquisitions. In a cash purchase situation, the equity simply converts to cash and you owe taxes on the gains you made. 

Founders have more options for reducing the tax consequences of an acquisition

Founders are generally in the best position to engage in tax planning and limit the taxable consequences associated with an acquisition. That’s because Qualified Small Business Stock (QSBS) allows founders to exclude the greater of $10 million or 10 times your tax basis from being taxed. Founders and investors can qualify for this tax exclusion if:

Early acquisition of company stock is key for founders to be able to qualify as QSBS and exclude a large portion of their gains from capital gains taxes.

Employees with equity face complicated tax questions

The acquisition of a company can leave employees facing choices about what to do with shares or facing varying tax consequences depending upon their individual situations. For example:

Some employees have both vested and unvested options as well as exercised shares, so may be facing many different tax implications as a result of an acquisition.

Actions You Can Take

  1. Receiving equity in the form of restricted stock or exercising options when they have the lowest cost basis enables you maximum flexibility if you leave a company and affords optimal tax rates on potential gains. 
  2. Transfer your company stock to a trust while the market value is lower and you could significantly reduce any gift transfer taxes and/or reduce your tax liability now and later if donated to a charitable trust. This strategy can also allow you to multiply QSBS eligible gains beyond $10M.
  3. Consider making a large contribution to a Donor Advised Charitable Fund if there is a year when you have a large tax from short-term gains/income related to equity actions. You can take the full deduction in the year of the contribution and give the money away over time.

Whether you are a founder or you have significant equity as an early employee, it can be very complicated and expensive to plan for the tax consequences when a company is acquired. Often, your best course of action is to work with an experienced tax advisor who can provide you with assistance limiting the taxes you’ll owe and preparing to pay the tax required as a result of the acquisition.

By getting professional advice from a CPA that has worked with several startup clients who have gone through various types of acquisitions, IPOs, or other liquidity events, you can keep your tax bill to a minimum and make the most of your shares. 

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