Tax Planning for When Your Startup is Acquired
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:
- 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.
- 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.
- 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:
- The company is organized as a C-corporation
- The C-corporation is a domestic company
- They’ve held their stock for more than five years
- The stock was issued after September 27, 2010 in order to be eligible for the full $10 million exclusion or was issued after August 10, 1993 to be eligible for a partial exclusion
- Aggregate gross assets of the company are valued at $50 million or less when the company is acquired.
- The business is active at the time of acquisition, it is not an investment entity, and at least 80% of company assets must be used to run the business
- The business does not fall into an excluded category, such as a professional service business, a finance company, a hotel or restaurant, or one where the company’s reputation rests upon the skill of one or more individual employees
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 planning 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:
- How much do you need to budget for taxes? Exercised shares are generally paid out in cash or converted to common shares of the new company. When the shares are paid out, you’ll owe capital gains taxes at short-term or long-term rates depending on the length of ownership. If you have exercised shares and the offer per share is below the price you paid, you can use the loss to offset other gains
- Should you exercise vested options? If the vested option is not cashed out, it could be swapped for an option from the new corporation or you could be given time to exercise it. Exercising an option doesn’t create a taxable event until you sell the stock acquired, but could produce an adjustment for alternative minimum tax equal to the difference in value between the stock acquired and the amount paid for it.
- What will happen to my unvested options? Unvested options could be swapped for an option in the new corporation. They could be cancelled and you could lose the value of unvested shares. Or the unvested option could be converted to cash, which is taxed as a bonus at your ordinary income tax rate. In some cases, unvested options vest on an accelerated schedule according to terms set during the acquisition.
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.
And then, for more medium-term planning, some broader questions for you to consider with a tax advisor (and possibly a financial advisor as well):
- What is the most tax-advantageous schedule for you to exercise options and sell shares over the course of several years? This is a complex consideration — you’ll have to plan out the cash you’ll need on hand to exercise some number of options and sell some number of shares (if any), ideally on a strategic schedule.
- Would you be willing to move to a state with lower taxes? (Particularly relevant in 2020.)
Actions you can take as an employee or founder
- 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.
- 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.
- 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.