Founders share tax can be confusing and tax mistakes are very expensive. Read ahead to learn how to avoid a huge tax bill if you are selling shares as a founder before an IPO.
More than ever before, founders are taking their companies public with less equity in their companies than in the past. In recent IPOs, founders only had an average of 7% stake in their companies, which is less than half of what tech company founders have had in the past.
It makes sense:
Companies are choosing to stay private longer instead of going public.
Sometimes, they want to stay private longer and do more private fund-raising rounds so they can have a higher valuation when they go for an IPO. Other times, they use things like tender offers to sell their shares to private parties before they’re available to the public.
Either way, the lesson is this: as a founder of a startup, you need to plan and prepare for multiple selling events of your shares, no matter what form they take: fundraising rounds with private investors, tender offers, IPOs, or a final exit after an IPO.
In this article, I’ll go over how to do it.
“Founders shares” isn’t any kind of technical or tax term – so don’t worry about adding more words to your financial vocabulary. They’re basically just the “shares” issued at the very beginning when a company is founded before any outside investors are brought in.
For example, let’s say you were one of three people who founded a company, and each person put in $500 upfront. In exchange, you received 5 million shares, since each share only cost $0.0001. If all three partners are equal, the company is “worth” $1,500 in the beginning, and everyone “owns” ⅓ of the company because each own 5,000,000 of the 15,000,000 total shares.
The math behind selling your founders shares is usually pretty simple.
Let’s say in your Series C round of fundraising, you decide to sell 25% of your shares at $6.25 per share.
Out of your 5,000,000 shares, 25% of those are 1,250,00 shares. Multiply that by $6.25, and you get a $7,812,500 payout.
When you sell your founders shares, you’ll usually have to pay both federal and state taxes on that income.
Most states, including California, don’t treat investment income differently than they treat income from a normal salary. So any money you make in selling your founders shares will be taxed at the ordinary income rate for your state.
The federal government, on the other hand, treats long-term capital gains differently than ordinary income tax. The rates are lower than what you’d pay on a normal salary. #ThankGoodness (Your founders shares will qualify as long-term capital gains if you’ve had them for more than a year before you sell.)
Typically, federal taxes for long-term capital gains are around 20%, with a net investment income tax of 3.8%, making your federal tax bill about 23.8% of what you earn by selling your founders shares.
Section 1202 of the IRS tax code excludes QSBS (qualified small business stock) from long-term capital gains tax.
To be considered QSBS, your shares have to have been held by you for at least five years.
So if we used the example above, selling 25% of your shares at a $7,812,500 payout would generate a long-term capital gains tax bill of $1,859,256 due to the IRS. But if your stock meets QSBS standards, you can avoid it. (Or keep that five-year date in mind for future sales.)
But what if you haven’t been in business for five years yet and you REALLY want to sell some of your shares?
Section 1045 of the IRS tax code lets you rollover your gain from the sell of your founders shares into a new investment of QSBS, if you re-invest the money within 60 days. Basically, you could go ahead and sell your shares, and then reinvest that money into another company that’s a small business that meets the QSBS guidelines to avoid the large tax bill. Then, after the five-year mark has passed, you can sell those shares and earn that income without having to pay the long-term capital gains tax.
The really good news is, your money doesn’t have to sit in that new company for five whole years. The five-year mark counts when you add together the time you held those shares in your company and in the new company.
So let’s say your company was four years old when you sold that 25%. You can re-invest the money from that sell within 60 days, hold it in the new company for one year, and then sell because you’ve now met the five-year mark.
Is a Section 1045 Rollover Always a Good Idea?
It is a great opportunity, but it may not always be the best option. Doing a Section 1045 Rollover just for the tax savings is sort of like letting the tail wag the dog. ???? Not always a terrible thing, but not necessarily the right approach.
Selling your shares before an IPO is an incredibly unique opportunity: the wealth you created by founding your company is now worth REAL dollars you can put in your bank account and start building more wealth on. Rolling that money over and tying it up in another company just to get QSBS tax benefits prevents you from doing this.
As a rule of thumb, I wouldn’t do a Section 1045 Rollover if this is the first time you’ve sold founders shares, or if your liquid net worth is less than $10 million.
So, let’s say you’ve sold your founders shares, you’re not going to to do a Section 1045 rollover, and you don’t qualify for QSBS because your business is less than five years old.
You’ve got to pay the tax bill, my friend. And your estimated federal tax on that sale is $1,859,256. You’ll need to plan to pay that money next April when you tax bill comes due.
But first things first, you’ll need to make sure you won’t get hit with an underpayment penalty. To do this, your withholdings from your paycheck and your estimated tax payments will need to total 110% of the tax you paid last year. If you’ve got that amount covered, then you’re good to go. If not, make an estimated payment now to get you to that 110% threshold. (It’s best to work with a tax professional to figure this out.)
After that, set aside the remainder of the $1,859,256 you’ll owe and put it into a high-yield savings account or a short-term bond fund. (I like to recommend parking funds for a tax payment in the DFA One-Year Fixed Income Fund, which may provide a higher rate of return than a typical savings account.)
Then, come April, pull that money out and pay your tax bill with it.
If you think it would be a good idea to follow suit of the companies that IPO’d in 2019 and sell more of your founders shares before going public, you’re in good company.
It can be a great strategy for personal wealth development, and lets you keep your company private longer, letting you up the value of it before the IPO.
If this is something you’re considering, or something you’ve already got planned, get in touch using the button below to book a call to talk about getting the most of the sale, and keeping your tax bill as reasonable as possible.
