A ‘two horses’ strategy to salvage a major tax break for investors in startups

Investors in startups and rank-and-file employees of companies that may one day hit the big time face a jolt in the federal spending and tax bill now making its way through Congress. But while the legislation calls for slashing major tax benefits for such shareholders, some wealth planners see a clever way to substantially avoid that pain.

Others say the possible workaround is uncertain.

Barely four months after the Treasury Department indicated there wouldn’t be any changes to tax perks for investments in early-stage companies, Democrats slipped a surprise into the $1.8 trillion climate and social spending bill passed by the House of Representatives on Nov. 19. Buried on page 2,213 of the legislation is a call to cut to 50% the amount of profits in early-stage companies on which investors can avoid federal tax. Under current law, investors can enjoy a 100% (75% on older investments) exemption on what’s known as qualified small business stock.

Investors in start-ups, along with their founders and employees, love qualified small business stock for its tax benefits.
Investors in start-ups, along with their founders and employees, love qualified small business stock for its tax benefits.

If the proposal becomes law, “it’s gonna hit someone who has just joined a startup that got acquired and all of a sudden has a life-altering amount of wealth,” said Bruce Brumberg, the co-founder and editor-in-chief of myStockOptions.com, an online compensation research and financial planning firm in Brookline, Massachusetts.

It’s not just entrepreneurs, seasoned executives and bright young things working for companies that aim to become a Twitter or a DoorDash who could rake in less money.

Brian Graister, the co-founder and CEO of Pennington Partners & Co., a private strategy and investment firm in Bethesda, Maryland, for entrepreneurs and family offices, said the proposal would also reduce profits for high net worth individuals who make under-the-radar "angel" investments in private companies that may one day hit the big time. “You’re planning to buy a house, and you’re assuming that liquidity would be tax-free, and now it wouldn’t be,” he said.

The Build Back Better bill’s proposed restrictions for the special stock, also known as founder stock, refers to equity that’s issued to start-up creators, their employees and investors pitched by Wall Street banks, private equity firms and wealth managers on promising companies. Founder stock isn’t routine shares in a publicly-traded company. It allows a shareholder to rake in $10 million or 10 times her original investment, whichever is bigger — those are the three key words — completely free of capital gains tax, now at a top rate of 23.8%. Investors who hold founder stock in companies that later go public and soar in value, like Zoom and Airbnb, can become multimillionaires or maybe even join the billionaire club overnight.

Under the bill before the Senate, investors with founder stock who earn more than $400,000, as well as all trusts and estates, regardless of their income levels, would be able to exclude only half of their gains from tax — not all of them, as is the current rule — when they sell after five years. That’s how long investors have to hold onto the shares before selling to get any tax benefit. The remaining 50% of profits would bear capital gains levies.

The 100% exclusion under the current rules covers stock issued on or after Sept. 23, 2010. Shares issued before then currently get a 75% or 50% tax discount. Either way, the proposal would slice everyone’s tax benefit by half.

One the one hand, that’s not a total disaster, advisors said.

“A maximized 50% benefit is better than nothing, so to speak,” said Kevin Brady, an assistant vice president and certified financial planner at Wealthspire Advisors in New York. But he added that “the reality of it is, people were planning in good faith and relying on” the current benefit.

For shares to qualify for the founder stock loophole, a company that issues them must at the time have gross assets — meaning cash — plus property and intangible assets like goodwill under $50 million. (A company’s valuation can be much higher.) The company also has to be a C corporation, not a partnership or other “pass-through” entity. It has to make something, which is why the benefit is popular with technology start ups and Silicon Valley. IRS rules don’t consider “service” firms like financial advisors, banks or brokerages to be making something, so they’re not eligible.

‘Two horses’
It’s unclear if the proposed curb will survive the Senate, or when the bill would be get a vote. But if it does, a few wealth managers and tax strategists have an idea. Call it the two-horses strategy.

Some strategists are eyeing ways to combine the tax benefits of QSBS with those of Opportunity Zones.
Some strategists are eyeing ways to combine the tax benefits of QSBS with those of Opportunity Zones.

The idea involves using a second lucrative tax benefit for investing in so-called Qualified Opportunity zones. Created during the 2017 tax-code overhaul under then-president Donald Trump, that perk allows investors in businesses and funds set up in low-income communities to avoid capital gains taxes on their profits after a decade. That’s twice as long as the time frame currently required for the tax break on founder stock.

Of the more than 8,700 communities eligible for Opportunity Zone funds under Treasury Department rules, more than a few are far from distressed, like some in Brooklyn; Austin, Texas; and Portland, Oregon.

Some core details: For an investment to qualify for the Opportunity Zones tax break, investors must put money into funds that make “substantial improvements” to the fund’s underlying physical holdings, from warehouses and office buildings to apartment complexes and storage facilities. The money must come from realized gains on prior investments on which taxes haven’t yet been paid. Hold on to the investment in the fund for 10 years, and the investor owes no tax on its appreciation. Perhaps the main detail: With so-called OZ investments, investors have to put in money that’s already been cashed out of other investments and on which they haven’t yet paid taxes. That’s where the role of founder stock comes in.

Here’s a simplified guide to what to do if the tax proposal passes, according to Blake Christian, an accountant and partner at accounting firm Holthouse Carlin Van Trigt in Park City, Utah.

Middle-affluent investors with income over $400,000 or trusts of any size would sell their founder stock, sucking up their loss of the 100% tax break and paying capital gains tax on half of their remaining gain. That tax hit can’t be avoided. Then they would roll that other chunk of money into an OZ fund within 180 days as required under IRS rules. After 10 years, all of the appreciation would be free of additional capital gains tax, meaning that the move preserves much of the tax-free benefit of the founder stock.

Another option: The founder stock seller can set up an OZ fund as a partnership or limited liability company (LLC) to invest in an OZ-qualified property or business.

Once the business starts to make money, the investor changes it to a C corporation — the required business form to issue founder stock — and converts her LLC’s shares to the special stock.

Remember that the time frame for OZ’s full benefit is 10 years, a period that many savvy investors consider too long. For founder stock, it’s only five years. Christian’s idea is that by Trojan-horsing founder stock into an OZ fund, the time frame for reaping tax-free gains from the fund can be cut in half.

Meanwhile, after at least 10 years, the investor can switch gears, telling the IRS as is allowed that she wants her founder stock in the OZ fund treated as ordinary shares. That move puts her no longer under the founder stock rules and her gains from the fund are 100% free of federal capital gains tax.

Christian said his private equity and venture capital clients “were like, whoa. This is amazing.” He called the strategy “riding two horses: the QSBS horse and the Opportunity Zone horse. You’re under the OZ umbrella, so when you sell it after 10 years, you’re home free.” He called the strategy “two bites at the tax apple.”

Not everyone is convinced that would work in reality.

Christopher Karachale, a tax partner at law firm Hanson Bridgett in San Francisco, said that the strategy “theoretically” makes sense. “But as a practical matter, I think it is highly unlikely” a business that qualifies to issue founder stock could operate in an OZ zone and meet the OZ requirements.

For example, he said, IRS rules say that an OZ investment needs to spend 63% of its cash on tangible property. But “none of these startups are going to spend that,” he said.

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