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Lane
Lane, JD, CFP, MBA, CRPS
Category: Finance
Satisfied Customers: 4186
Experience:  Providing Financial, Tax & Business advice since 1986
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I am starting a company (probably an LLC) with two partners.

Resolved Question:

I am starting a company (probably an LLC) with two partners. Our institution will get a fraction of shares in return for their interest in the intellectual property. The plan is to merge shortly thereafter with another firm that will provide sales and executive support; they have an ongoing revenue of about $4M annually. Can we issue founder shares free of current tax liability, and what are the long-term holding implications of them?
Submitted: 1 year ago.
Category: Finance
Expert:  Lane replied 1 year ago.

NPVAdvisor :

Hi,

NPVAdvisor :

TO answer your questons.. I'll need more information ... First if you will be a multi-member LLC, you'll be taxed as a partnership, and the term "shares" would not apply

NPVAdvisor :

Secondly, if you would tell me about the entity type (S-Corp, C-Corp, LLC, ect) of the firm with which you intend to merge

Customer:

The company we would merge with is Clintara, LLC

NPVAdvisor :

things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes.
There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.

NPVAdvisor :

Sorry only a part of that posted, but now that your provided the entity type let me tell you this ...

NPVAdvisor :

Before you can merge two LLCs, you need to create a plan of merger. Gather the owners of each LLC to draft the plan. Include the name of each LLC party to the merger and the name of the surviving LLC into which the other LLC will be merged. Identify the surviving entity as an LLC. Set forth the terms and conditions of the merger, the address of the LLC’s principal place of business and the manner and basis for converting the interests of the existing LLCs into the interests or obligations of the surviving LLC.

NPVAdvisor :

You have to do this using the pre-approved process with the state of MA sec of state

Customer:

With respect to multi-member LLC, I think we would elect to be taxed as a corporation, so that we did not pay taxes on income that was retained or used for research, only on dividends, although I could be persuaded otherwise. With respect to the 83(b) election, I think we would do that, but I read that this could be taxed at inception.

NPVAdvisor :

OK first, just to be sure we're on the same page... that makes sens for C-corp, not the S-corp (which is a pass-through)

Customer:

Your suggestion sounds like a good one, I just want to clarify a few things.

NPVAdvisor :

And yes the 83B election is just for that purpose

NPVAdvisor :

So that you're taxed on a share that has a very low valuie... rather than being taxed lated at vesting when the stock is worthe a lot more

Customer:

1. We found the LLC, take 83(b) elections and pay no tax up front.

Customer:

2. We file to tax ourselves as a C-Corp

Customer:

1b. the institution is part of the LLC (?)

Customer:

3. When we merge with the other LLC we use the MA sec of state process and we still don't owe taxes upon the merger.

NPVAdvisor :

1. We found the LLC, take 83(b) elections and pay no tax up front. ... this would be correct as long as you do it early enough that the stock has no value

Customer:

4. When we sell we get (?) benefits due to the 83(b) election. I read somewhere 10M tax free?

Customer:

How much time would have to elapse before the merger to make a fair claim of no value?

NPVAdvisor :

Hang with me here....

NPVAdvisor :

2. We file to tax ourselves as a C-Corp ...


Form 8832, Entity Classification Election

NPVAdvisor :

1b. the institution is part of the LLC (?) ... I don't know what this means What institution are you referring to?

NPVAdvisor :

3. When we merge with the other LLC we use the MA sec of state process and we still don't owe taxes upon the merger.... That's right and doing this through the SOS is not a choice

Customer:

Tufts Medical Center was the institution of record for grants under which our product was developed. Our product is a protocolized counseling intervention.

NPVAdvisor :

4. When we sell we get (?) benefits due to the 83(b) election. I read somewhere 10M tax free? the 87 b election is simply to be taxed now (while the shares are worth less - rather than wait to be taxed (we're talking about compensation here not capital gains)

Customer:

We are in negotiations with them. They want to do something completely different that we think is a terrible idea.

NPVAdvisor :

tell me about it

Customer:

They want to set up an LLC in which they are 100% owners and they give us royalties through the "usual" arrangement, where the inventors get 30% of the profits.

Customer:

One of our colleagues had a similar arrangement with Massachusetts General Hospital and wound up with very little.

Customer:

We would be completely at the mercy of the Medical Center.

NPVAdvisor :

If your are the developers of the property, sounds to me like they're not only asking you to give up ownership, but also control and management rights ... What if they don't use the property wisely? ... If you believe you can do that better than them I thingk you're right ... HOWEVER ...

NPVAdvisor :

If they have market access you don't have ... successful rack recore with similar int property, maybe you take your rpoyalties and play golf?

Customer:

They have no market access. They wouldn't have the foggiest idea.

Customer:

They give medical treatments. Our thing is done over the phone to corporate employees. It will be 50 states and internationally.

NPVAdvisor :

Then I think your intuition is good ... Id' counter with that idea exactly...AND if you use the LLC merger idea, you can lay EVERYTHING out in the operating agreement (this would be a part of the requiredmerger plan with MA

NPVAdvisor :

How much is their sale expertise worth to you?

Customer:

So two final details. When we sell our interest, is it all capital gains or is there an exclusion or preferential treatment as founders? And if we bring in the institution early, would that risk our assertion of no value?

Customer:

We are not sales people. I provide the technical and IT and some business experience. One partner is a psychiatrist, and the other is a sociologist/work expert.

NPVAdvisor :

Ok. first, if you merge as LLC's the Corporation change comes later ... and there ARE reasons to merge AS LLC's... see this: http://smallbusiness.chron.com/merge-llcs-42118.html

NPVAdvisor :

IF you want to elect C-corp early on and issue the founders stock as worthless or close, then you'll need to dpo that BEFORE the merger

NPVAdvisor :

THe merger, with a company with that kind of revenue completely destroys the no value idea

Customer:

If we did the LLC in this calendar year and elect on day 2, and then merged on 1/2/2014 would that be enough separation?

NPVAdvisor :

I would simply lay out an operating agreement that specifies ownership[ %, management rights, etc then you will have ownership WITHOUT a taxable event

NPVAdvisor :

Sorry hang on...(to your questions)

NPVAdvisor :

(question) probably not, IRS will use substance over form doctrine to say you did that simply to avoid... AND now you have a whole different set of issues... merging a C-corp with an LLC

NPVAdvisor :

Merging a C corporation into an LLC taxed as a partnership often results in a large tax bill. This is largely because the IRS considers this kind of merger to be a liquidation of the corporation for which the corporation will owe tax, on top of which the corporation’s stockholders will also be taxed personally on the corporate assets assumed to be distributed to them; in other words, there is double taxation.

Customer:

Why don't you answer my question about taxes on sale first on the assumption that we have a good 83(b) exclusion and it happens in 5 years. What would the terms be then?

Customer:

Then I will lay out the timeline I am thinking of as a result of this conversation.

NPVAdvisor :

Ok first you'r talking apples and oranges (83b election is to minimize INCOME TAX on the compensation (think of this as wages) that happens with the granting of stock .. by taxing it to you now at a lower value ... THAT this has just the oppoit effect from a sale 5 years later because you basis in that stock is the value as of the 83b election

NPVAdvisor :

If you're trying to minimize the capital gains later then go ahead and let it vest over 5 year a year at a time so you'll have a higher basis

NPVAdvisor :

this is a cake and eat it too issue

NPVAdvisor :

:)

NPVAdvisor :

I would keep as much ownershp as possible to control your iidea, and do the merger

Customer:

I understand it would be capital gains in 5 years and that's good. We don't have funds to pay taxes on stock that is vested at higher values. I just want to understand what the capital gains tax would be after the 5 years. Is there also an exclusion1. We found 10/1/2014 with agreement and file 83(b) immediately. We reserve a share for our institution that is held by the

Customer:

My question and my list got intertwined by the website.

NPVAdvisor :

Here's what I saw last... want to finish that question? "I understand it would be capital gains in 5 years and that's good. We don't have funds to pay taxes on stock that is vested at higher values. I just want to understand what the capital gains tax would be after the 5 years. Is there also an exclusion1. We found 10/1/2014 with agreement and file 83(b) immediately. We reserve a share for our institution that is held by the..."

Customer:

.. is there also an exclusion? (end of question)

NPVAdvisor :

NO.. what exlusion?

NPVAdvisor :

83b is about compensation AND fixes the basis at a low value

Customer:

I read somewhere about a $10M exclusion of capital gains for founder stock. I'm not sure it applies to this scenario. That's what I'm asking.

NPVAdvisor :

I think you are thinking about this (which really does not apply to your situation... this is relief for thase selling C-sorp interests or converting to S-Corp or some other entity where there is ALREADY buil it years of untaxed gain

NPVAdvisor :

See this:

NPVAdvisor :

On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (the Act). Among other provisions, the Act provides that the 100% exclusion from gross income of certain capital gains from sales of qualified small business stock will apply to investments madeafter September 27, 2010 and before January 1, 2014, including investments made in 2012 that were not eligible for the exclusion prior to the passage of the Act.

NPVAdvisor :

To qualify for the 100% exclusion (in addition to completing the acquisition after September 27, 2010 and before January 1, 2014), all of the other requirements applicable to investments in qualified small businesses must be met, including, among other things:



  • The stock must be held for more than five years (subject to certain exceptions for qualifying tax-free “rollovers”);


  • The exclusion applies only to noncorporate taxpayers;


  • The small business must be a domestic C corporation (an S corporation is ineligible);


  • The original issuance of the stock must be acquired from the corporation (directly or through an underwriter);


  • The corporation must meet certain “active business” requirements, meaning generally that it must use 80% of its assets (by value) in a qualifying active business (excluding certain types of businesses, such as financial institutions, farms, professional service firms, hotels and restaurants and similar businesses) for substantially all of the investor’s holding period;


  • The corporation must not have made certain redemptions of its stock prior to or following the acquisition of the stock; and


  • The aggregate gross assets (defined generally as cash plus the aggregate adjusted tax basis of other property) held by the small business must not exceed $50 million at any time before orimmediately following the investment by the investor (including amounts received by the small business from the investor).

NPVAdvisor :

So yes for a corporation that is true... But the merger with the LLC is a whole different bucket of worms

Customer:

I guess a C-corp is an option instead on an LLC?

NPVAdvisor :

There ya go

NPVAdvisor :

Companies that are just being formed, or are currently not structured as domestic C corporations (such as limited liability companies), should consider whether being formed as, or converting to, a domestic C corporation could permit equity holders of the company to benefit from the 100% exclusion.

NPVAdvisor :

SO

NPVAdvisor :

unless you really NEED this other firm setting up as C-originally make the most sense .. it's just that this merger idea really convolutes things

Customer:

We need some time and experience to figure out if Clintara is an ideal partner. If we postponed the merger, and we formed as a C-corp, would that work?

Customer:

We could make an agreement to provide services in return for a share of revenue prior to merging.

NPVAdvisor :

Yes, forming as the CoCrop before the end of 2013 p[reserves the exclusion option ... and yes they can certainly pay you via contract with your C-corp

NPVAdvisor :

Sorry 2014

Customer:

Option 2:
1. We found C-Corp on 10/1/2013. Issue founder shares (untaxed).
2. We put shares in treasury for the institution and complete negotiation with them for the IP.
3. We make an agreement with Clintara to provide sales and executive support in return for a share of 2015 profits.
4. If this works out in 2015 we make agreement to merge 1/2/2016. THis could be a tax free merger if we don't collect $?
5. We can sell with exclusions of tax after 10/1/2018.

NPVAdvisor :

You have your arms aroun it

Customer:

For reference, this was Option 1:



1. We found LLC 10/1/2013 with agreement and file 83(b) immediately. We reserve a share for our institution that is held by the LLC.


2. We file the 83(b)


3. We give the institution its share in return for the IP rights.


4. We make an agreement with Clintara to provide sales and executive support in return for a share of profits.


5. Assuming the arrangement is successful, merge with Clintara on 1/2/2015 using MA sec of state procedure.


6. When we sell in 1+ years, we would be taxed as long term capital gains, no exclusions.

NPVAdvisor :

That's right

Customer:

OK this is good. If you think these are the two plans that are best, XXXXX XXXXX what I wanted to know. This has been extremely helpful.

NPVAdvisor :

Option 1 wins in my opinion

NPVAdvisor :

Glad I could help you think it through

Customer:

great, thanks.

Lane, JD, CFP, MBA, CRPS
Category: Finance
Satisfied Customers: 4186
Experience: Providing Financial, Tax & Business advice since 1986
Lane and other Finance Specialists are ready to help you
Expert:  Lane replied 1 year ago.

Thanks for the rating bill.

Go get em

Lane

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