Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

A: If you exercise your warrant by paying cash for the exercise price, your capital gains holding period does not start until you exercise your warrant.  (Unfortunately, there is some uncertainty as to whether the holding period starts on the day of the exercise of the warrant or the day after.  See here.) 

If you exercise your warrant in a cashless exercise, there is uncertainty as to the right answer.  Some taxpayers argue that the cashless exercise of a warrant is a recapitalization event itself entitling the taxpayer to tack their holding period back to the date of the acquisition of the warrant.  See the attached letter, in which the New York State Bar Association states:  "If a cashless exercise constitutes a recapitalization, the warrant holder's holding period for the stock received upon exercise would generally include the holding period for the warrants."  

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Yesterday Davis Wright Tremaine LLP, Clarity Health Services, Faultline Ventures and iMedExchange hosted the first innovateHealth Capital Summit at the Seattle offices of Davis Wright Tremaine. More.

innovativeHealth is a fast-growing group of health care technology and services stakeholders focused on driving innovation in the health care industry and building awareness of the health care services and technology cluster in the Pacific Northwest. innovativeHealth both connects our members within the region and connects our cluster to the larger national and global markets.

The group's first two events were standing room only. More than 50 health care organizations were represented at the March 2009 event, which focused on entrepreneurial opportunities created by the Obama administration's stimulus plan, budget and health reform initiatives.
 

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In what could be a serious blow to the venture fund industry, the President's tax proposals contemplate taxing carried interest as ordinary income, subject to ordinary income tax rates and self employment taxes.

The proposal states that it "is not intended to adversely impact qualification of a real estate investment trust owning a carried interest in a real estate partnership."

Excerpt from a summary of the President's proposal is below.  You can also find them on pages 25 and 26 of this document.

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In what could be a very welcome development in startup land, if it becomes law, President Obama has proposed that there be NO capital gain taxation of gains from the sale of qualified small business stock issued after February 17, 2009 and held for 5 years.  Presumably the limitations of IRC 1202 that cap the QSB benefit at the greater of (i) 10x a taxpayer's basis in stock issued by the corporation and disposed of during the year, or (ii) $10M reduced by gain excluded in prior years on dispositions of the corporation's stock would still apply.  However, this would still be quite a benefit.

See pages 13-14 of this document.  The entirety of pages 13 and 14 are also quoted below.

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"When X, an entity classified as a partnership for federal tax purposes, elects under § 301.7701-3(c)(1)(i) to be classified as an association for federal tax purposes, the following steps are deemed to occur: X contributes all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter X liquidates by distributing the stock of the association to its partners. Under § 301.7701-3(g)(3)(i), these deemed steps are treated as occurring immediately before the close of the day before the election is effective. Thus, the partnership’s taxable year ends on December 31, 2009, and the association’s first taxable year begins on January 1, 2010. Therefore, the partnership will not be deemed to own the stock of the association during any portion of the association’s first taxable year beginning January 1, 2010, and X is eligible to elect to be an S corporation effective January 1, 2010. Additionally, because the partnership’s taxable year ends immediately before the close of the day on December 31, 2009, and the association’s first taxable year begins at the start of the day on January 1, 2010, the deemed steps will not cause X to have an intervening short taxable year in which it was a C corporation."

Rev. Rul. 2009-15.

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I typically prefer C corporations as a choice of entity for early stage technology companies.  However, occasionally a pass through entity is the right choice of entity, especially when the founders will fund the initial losses and want to deduct those losses on their individual tax returns (i.e., pass through income tax treatment).  Which raises the question, what is the better choice of entity today for a startup company whose founders are going to be actively involved, fund early losses, and want the ability to deduct those losses on their personal income tax returns—an LLC (for this purpose, one assumed to have multiple members and taxed for federal income tax purposes as a partnership) or an S corporation?  (Mind you, a flow through entity choice will cost the founders the qualified small business tax benefit of IRC Section 1202 and the rollover benefit of IRC Section 1045.)

The answer depends on a number of factors, including whether the founders want to specially allocate the early losses among themselves (meaning, share them other than in proportion to stock ownership). Special allocations aren’t allowed with an S corporation. But if there is no desire to specially allocate losses, I believe the S corporation is the better choice—assuming the entity meets the criteria for making an S election. Why?

• S corporations can participate in tax-free reorganizations -- S corporations, just like C corporations, can participate in tax-free reorganizations (such as a stock swap) under IRC Section 368.  LLCs with multiple members taxed as partnerships cannot participate in a tax-free reorganization under IRC Section 368.  This is a significant reason not to choose the LLC format if a stock swap is an anticipated exit strategy. The last thing a founder wants to discover on a proposed all stock acquisition is that the stock received will be taxed, even though non-liquid.
• S corporations can grant traditional equity compensation awards -- S corporations can adopt traditional stock option plans. It is very complex for LLCs to issue the equivalent of stock options to their employees, and although they can more easily issue the equivalent of cheap stock through the issuance of “profits interests,” the tax accounting for a broadly distributed equity incentive plan in an LLC can be very complex and costly. 
• S Corporations Can More Easily Convert to C Corporations -- It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation.  For example, upon accepting venture capital funding from a venture fund, an S corporation will automatically convert to a C corporation. For an LLC to convert to a C corporation, it is necessary to form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC. Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.
• There May Be Employment Tax Savings Associated With An S Corporation -- An S corporation structure may result in the reduction in the overall employment tax burden. LLC members are generally subject to self-employment tax on their entire distributive share of the LLC’s ordinary trade or business income, where S corporation shareholders are only subject to employment tax on reasonable salary amounts and not dividends.
• Sales of Equity and Initial Public Offerings -- S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder (generally) restrictions) than LLCs. For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler and less complex). An LLC will often have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event). As a practical matter, an LLC will need to transfer its assets to a new corporation or merge with a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure.
• Simplicity of Structure -- S corporations have a more easily understandable and simpler corporate structure than LLCs. S corporations can only have one class of stock -- common stock -- and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).

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I am frequently asked this question by founders--is there a potential for employment tax savings if an S corporation is the choice of entity rather than a limited liability company?

The short answer is yes--there is a potential for employment tax savings.

The reason for this is because with an S corporation employment taxes only apply to the salaries paid to the owners, not to dividends.  With a limited liability company, an owner must pay self employment taxes on the owner's entire distributive share of self employment income.  Self employment taxes are 15.3% of self employment income up to the FICA wage base limit, and then 2.9% of self employment income beyond the FICA wage base limit.

You may also find these articles helpful:  Forbes, New York Times, Wall Street Journal.

The catch?  S corporations must pay their owners a reasonable salary.  This is a hot button issue for the IRS.  The corporation itself must also pay federal unemployment tax on salaries.  

The upside?  Potentially significant employment tax savings.  

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