Due to the dynamic nature of launching a new business, it can be challenging for a startup to keep up with all of the latest changes to the tax code.
In this blog, we’re focusing on Founders Stock and how businesses can leverage this great tax provision.
Messy books mean you’re likely paying the wrong amount in tax.
Clean books are essential for on-time and accurate tax returns. So, how do
your books look? Get the answers you need below.
What is Founder Stock?
Founder Stock is a Qualified Small Business Stock (QSBS) that provides a tax exclusion on gains to taxpayers in certain small business stock sales. When selling qualified stock, an individual can exclude gains of up to $10 million or 10 times the adjusted basis of stock in gains from income tax.
Founder Stock is outlined in Section 1202 of the Internal Revenue Code on the IRS website.
Tax Benefits of Qualified Small Business Stock:
The tax credit you need to know for Founder Stock is Qualified Small Business Stock. The proceeds of your first $5M are taxed at 0.
Obviously, that’s the goal here. Save your business a lot of money in taxes as it grows. But it’s not quite that easy – you’re going to have to jump through three big hoops…
Hoop No. 1: Show Proof as Qualified Small Business Company
Most early-stage C corporations have the ability to meet the QSBC requirements, which are outlined in Section 1202:
- The stock must be in a domestic C corporation
- The corporation must have less than $50 million dollars in revenue or assets on the date the stock is acquired.
- The majority (80%) of the value of the corporation’s assets must be actively used in the handling of the qualified businesses – not an investment vehicle or inactive business.
Hoop No. 2: File Your 83(b) Election
From there, you’re going to want to file an 83(b) Election with the IRS to dodge pretty hefty taxes.
Section 83(b) Election is a short document that says you would like to be taxed based on the fair market value of the stock when it’s granted instead of the fair market value on the date that it vests. Otherwise, you’ll pay taxes on the date the stock vests.
However, you must file within 30 days of receiving the Founders Stock. It’s a small window, so don’t miss it!
Hoop No. 3: Hold the Stock for 5 Years
You must own the stock outright for 5 years before you can sell. If you decide to sell earlier, you will not qualify for QSBS.
Below are the FAQs we answered:
What happens when a company grows past the $50 million mark?
There’s a $50 million aggregate for the gross assets, If I acquire my stock while it’s below that threshold and someone else acquires the stock after it exceeds that threshold; my stock would qualify, theirs would not.
Even though the business grows beyond the limit, it does not prevent earlier shareholders from taking the exemption from 1202. So if you start a small business that becomes fast growth, once the threshold is passed you don’t lose the benefit of the stock prior to surpassing the limits. Only the stock acquired beyond the limits would not qualify.
What if an exemption exceeds your gain?
You’re limited to the gain identified. If I generated a $9 million gain and could have excluded $10 million, I’m limited to only utilizing $9 million of the exclusion.
What are the potential pitfalls here?
First, the five year requirement is critical. Second, there are legal and financial caveats to consider when electing to become a C Corporation. To take advantage you have to sell the stock. Buyers generally want to buy assets because with stock, they inherit any liabilities and prior issues.
Finally, if you don’t meet the 5 year requirement, you may still be able to save the benefit. In cases where you have stock from one qualified small business and roll that into another qualified small business within 6 months, you benefit from currently excluding the gain. This also may create a situation to not lose the benefit.
Who should take advantage of Section 1202?
If you’re already a C corporation, there’s no reason not to take advantage of this provision. You didn’t have to know about it when you set it up to take advantage of it. You just need to make sure to take the appropriate steps when it’s time to sell the stock.
If you were going to set up a new company today, this would be one of the factors in deciding what type of entity best fits your company structure. Founders and the professional advisors should review the business model, the investors, goals, exit strategy, timeline, etc. to elect the best entity.
Are a lot of professional advisors in the SaaS space aware of this?
I don’t think so. Tax exemptions are not as well evaluated in setting up an entity. These types of provisions are more commonly reviewed during tax prep and potential exit.
Making sure to leverage an established CPA who is specialized on these types of tax issues during setting up a company provides benefits throughout the years of your ownership.
What type of shares do founders get?
How do you issue stock to founders?
Most people use an attorney to issue common stock in a C corp or an S corp to the founders, especially when they’re gonna think about vesting requirements. And if they’re in an LLC or a partnership they issue the membership interest in a similar fashion.
Usually, the founders that start the business (AKA they are there from the inception), pay some kind of token amount to put the money in the business…a hundred dollars, a thousand dollars, something like that. Technically they pay for their stock at the par value. It’s not uncommon to see that as low as a 10th of a penny or a penny per share.
And technically if they don’t write a check into the company, they should be reporting the stock they receive as income at that penny value or that 10th of a cent value. Usually, it’s somewhere in the $40 to $50 range when you see people when they’re issuing it. At some point in fashion, yes, you pay for your founder stock.
What is founder stock vesting and why do people do it?
Unfortunately, when you’re thinking about vesting for founder stock, you need to be thinking of the worst-case scenario.
So, if there’s four of you when you start and you each have a fourth of the company, what’s gonna be fair if one of those people leaves in one year or two years or three years or four years — have you thought through that process? You can think, oh, really, to earn 25% of the company, they need to stay here and help us build this company for the first four year years. That means you should have four-year vesting.
Now, most people ratably vest. That means they vest some every single month. So if they leave at 13 months, they get 13/48s of their company that they earned. So, they earned at least a portion of what they were promised, but they didn’t earn the remaining. The remaining goes back to the company because they didn’t fulfill their commitment (they didn’t stay the four years and stick it out with the other founders).
Vesting is a way to protect the founders that stick it out the full four years while still compensating the other founders partially if they leave before that four years is up.
How do you split shares between founders?
A lot of how you split up founders shares is a negotiation, and it comes down to understanding each others’ relative value. Some of the things people think about when splitting up that ownership, though, are a) who’s putting in cash and b) how long do you require people to best in their shares for those people not putting in cash.
Usually, if people are putting in cash, they allow for that to be fully vested (they own a full chunk of the portion they put in for cash). And usually, if people are putting in time, they require some kind of time commitment, whether it’s two through three or four years for people to earn that stake in the company
How is founder stock taxed?
There are really only two ways it’s seen by the IRS. The first way is, if you do nothing initially, you are taxed at the value of the shares as they vest. So if you’re vesting over four years, whatever tranche vested is what you’re taxed on. It’s like you’ve received income for those shares. These are shares that you have not bought that you’ve been granted for being a founder.
The second way is to do a tax strategy. Have you ever heard of an 83(b) election? It’s something you have to do, and you have to do it timely. As soon as you’re granted the shares, you should be sending the IRS an 83(b) form. What that does is accelerate that tax to today.
So, you file that within 30 days of getting your restricted stock grant or your founder stock grant, and you pay the full value of those shares at the time you’re granted, which is usually hundreds or thousands of dollars. You’re usually only writing a $200 check for tax or a $500 check for tax — something nominal compared to the expected value you expect to see when you fully invest.
Who should take advantage of section 1202?
Founders that file an 83(b) election start the clock — the QSBS clock or the 1202 clock — which allows them — if they hold their stock for five years — to eliminate the capital gains on the first $10 million of proceeds that they have on their small business.
Lots of caveats here, though! You’ve gotta be a C corp. You’ve gotta have less than $50 million of assets. When you get the shares, you’ve gotta have them for five years.
As I said, there are lots of caveats, so check with your tax person. There’s the potential for huge, huge benefits for founders.
Is restricted stock and founder stock the same thing?
So is restricted stock the same thing as founder stock? The simple answer is yes. Really, everything’s just common stock for founders. The restricted stock comes into play, and that’s the term accountants use. So if your founder stock vests over time, it’s technically referred to as restricted stock, which is the same thing as common stock with restrictions, right?
The Takeaway on Founder Stock…
Tax exemptions are not well evaluated in setting up an entity. These types of provisions are more commonly reviewed during tax prep and potential exit. Making sure to leverage an established CPA who specializes in these types of tax issues from your initial company set up provides benefits throughout the years of your ownership.
If your business is a C corporation, it would be worth the time to consult with a specialized CPA. If you need help navigating the IRC, small business tax prep, or finances, check out our tax services.
Additional Tax Resources That You May Find Helpful:
- Small Business Tax Credits & Deductions That You Might Be Missing
- 2023 Business Tax Filing Deadlines
- Startup Cost Deduction
- Your Small Business Tax Preparation Checklist
- The 1099 Form: Everything You Need to Know About Filing
- Free Quarterly Tax Payment Calculator
- Here’s the Best Time to Get Tax Advice From Your Small Business CPA