Business entities often look to outside investors for funds they need to achieve their objectives. For better or worse, tax considerations often factor into preparing for, structuring and effecting an investor financing. This article considers how various tax rules may bear on financings.

I. Entity of Choice.

a. Venture Capital Funds.

Venture capital (“VC”) funds typically prefer that operating companies they invest in be C corporations.  Historically, the preference for C corporations has in large part been driven by tax issues arising from investments by VC funds in “pass-through” entities.  Although VC funds generally are not able to invest in S corporations (because the VC funds are partnerships and want preferred equity positions), they can invest in limited liability companies (“LLCs”) and other tax partnerships.  If a VC fund invests in an LLC that engages in a U.S. trade or business, however, the operating income from the LLC flowing through the VC fund to investors in the VC fund constitutes (i) “unrelated business taxable income” (sometimes referred to as “UBTI”) in the hands of tax-exempt investors in the VC fund and (ii) income that is effectively connected with a U.S. trade or business (sometimes referred to as “ECI”) in the hands of non-U.S. investors in the VC fund.¹  The expansion of the “qualified small business stock” exclusion discussed below (given that VC funds tend to hold their investments for long periods of time) and, more recently, the reduction of the top corporate tax rate to 21% (given that companies VC funds invest in tend to retain any earnings they have) have further enhanced the C corporation as the operating company of choice for investing VC funds.²

1. Change of S corporation or LLC to C corporation.  A VC fund will typically require an S corporation or LLC in which it wants to invest to become a C corporation as a condition of its investment.³

A. S to C.  An investment by a VC fund in an S corporation automatically terminates the corporation’s S status under Code Section 1362(d)(2) on the date on which the investment is made (because the VC fund is not a qualifying S corporation shareholder and because, if the VC fund acquires preferred stock, the corporation now has more than a single class of stock).  If an S corporation taxable year of the corporation has begun, the last day of the S corporation year is the day before the investment by the VC fund.  The remainder of what would have been the S corporation taxable year is a short C corporation year.  The tax items for the year of the termination are allocated between the short S and C portions on a pro rata basis (by numbers of days in each portion) under Code Section 1362(e) unless (i) all of the shareholders consent to the application of normal tax accounting rules to the two periods or (ii) there is a sale or exchange of 50% or more of the stock in the corporation during the year.  For a limited period of time after the termination of a corporation’s S status (the period is referred to as the “post-termination transition period”), the corporation may make (under Code Section 1371(e)) tax-free cash distributions to its shareholders with respect to their shares to the extent of its accumulated adjustments account.

B. LLC to C.  Revenue Ruling 84-111, 1984-2 CB 88 describes three methods of incorporating a partnership and the tax consequences of each of the three methods.  Under the first method, the partnership contributes its assets to a newly formed corporation in exchange for all of the outstanding stock of the corporation (and the assumption by the corporation of its liabilities) and then distributes the stock to its partners in a liquidating distribution.  Under the second method, the partnership distributes its assets to its partners (who assume the partnership’s liabilities) in a liquidating distribution, and the partners then contribute the assets to a newly formed corporation in exchange for all of the outstanding stock of the corporation (and the assumption by the corporation of the liabilities).  Under the third method, the partners of the partnership contribute their interests in the partnership to a newly formed corporation in exchange for all of the outstanding stock of the corporation, and the partnership then liquidates for tax purposes into the corporation (with the partnership assets and liabilities becoming assets and liabilities of the corporation).  These days, the simplest way for an LLC to become a corporation is for the LLC to “convert” to the corporation under the applicable state conversion statute(s).  Revenue Ruling 2004-59, 2004-24 IRB 1050 treats a conversion as an incorporation under the first method described in Revenue Ruling 84-111.⁴  In any event, each of the three methods is analyzed under a combination of Code Sections 351 and 731 and their respective ancillary provisions (with neither the post-contribution distribution under the first method nor the pre-contribution distribution under the second method preventing the satisfaction of the control test applicable under Code Section 351).⁵  Depending on the circumstances, however, the method chosen may affect the tax consequences of the incorporation (including the amount and character of any boot gain, the bases the former partners take in their shares of stock in the corporation, and the bases the corporation takes in the assets formerly held by the partnership).  Those utilizing the second method should also beware Code Sections 704(c)(1)(B) and 737 if the distributed assets include any that have been contributed to the partnership during the prior 7 years.⁶

2. Investment structure. If continued S corporation or LLC status for a portfolio company is desirable and agreeable to an investing VC fund, structuring an investment by the VC fund as debt with equity-like features (such as contingent interest or convertibility) and/or a warrant might be worth considering.  In that case, though, care needs to be taken to ensure that the form of the arrangement will be respected for tax purposes.⁷  If the operating company is an LLC, it might also be possible to have the VC fund make an equity investment in the LLC through a wholly owned C corporation formed by it to make the investment (such a C corporation is sometimes referred to as a “blocker” corporation).⁸ 

b. Angels.

Individual investors (sometimes referred to as “angels”) may be more willing than VC funds to invest in pass-through entities.⁹  U.S. resident individuals can hold shares in S corporations.  If the existing entity is an S corporation and the investors want preferred shares, however, their acquisition of preferred shares will terminate the corporation’s S status.  In that case, assuming continued pass-through tax treatment is desirable, an acceptable alternative may be for the investors and the S corporation to form a new LLC to which the S corporation contributes its assets (and which assumes the S corporation’s liabilities) and the investors contribute their investment amounts.¹⁰  Unfortunately, because Code Section 336 applies to liquidating distributions by S corporations, the S corporation will likely have to remain in existence as the entity through which the existing owners hold their interests in the LLC (unless the liquidation can be effected with certainty as to the absence of built-in gain).¹¹  The continued existence of the S corporation may complicate the investment documents among the various stakeholders (particularly with regard to transfer restrictions and also possibly with regard to voting).

II. Qualified Small Business Stock.

Code Section 1202 allows a non-corporate taxpayer who has acquired “qualified small business stock” (or “QSBS”) after September 27, 2010 and who has held the QSBS for more than five years to exclude 100% of the gain recognized on a sale of the stock.¹²  For stock to be QSBS, it must have been acquired upon original issuance for cash, other property (excluding stock) or services (other than as an underwriter) from a C corporation that, among other things, satisfies certain “qualified small business” and “active business” requirements.¹³  The “qualified small business” requirement limits the applicability of Section 1202 to stock issued by corporations with aggregate gross assets of $50 million or less.  The “active business” requirement limits the applicability of Section 1202 to corporations most of whose assets are used in one or more “qualified trades or businesses” (which exclude, among other things, providing professional services such as law, engineering, accounting and actuarial science).  In addition, the corporation may not have redeemed more than de minimis amounts of its outstanding stock within specified periods of time before or after the issuance of the stock in question.  “Look-through” rules can allow an S corporation or partnership to pass the benefits of Section 1202 through to its owners.¹⁴

When Section 1202 was originally enacted in 1993, only 50% of the gain on a sale of QSBS held for more than five years was excludible.  Any gain that was not excludible due to the percentage limitation was taxable at a maximum rate of 28%.  In addition, a portion (7%) of any excluded gain was a preference item under the alternative minimum tax.  With the maximum excludible portion of the gain on a sale of QSBS limited to 50% and the non-excludible portion of the gain taxable at a 28% rate, Section 1202 lost much of its luster in 2003 when the maximum rate generally applicable to long-term capital gains from stock sales was reduced to 15%.  The American Recovery and Reinvestment Tax Act of 2009 breathed some new life into Section 1202 by increasing the maximum excludible portion to 75% for QSBS acquired after February 17, 2009 and, as enacted, before January 1, 2011.  Subsequent legislation increased the maximum excludible portion to 100%, and exempted excluded gain from the alternative minimum tax, for QSBS acquired after September 27, 2010.

III. Rights of Preferred Stockholders.

a. Terms.

Holders of shares of preferred stock of a C corporation may have, among other things, (i) rights to an accruing dividend (which may be expressed as a percentage per annum of their investment amounts), (ii) rights to receive their investment amounts plus their accrued but unpaid dividends upon the corporation’s liquidation before common stockholders receive anything,¹⁵ (iii) rights (and obligations, typically in connection with an initial public offering by the corporation that meets specified parameters) to convert their preferred shares to common shares, (iv) rights to have the corporation redeem their preferred shares after a specified date (typically at a price at least equal to the amount they paid for their preferred shares plus their accrued but unpaid dividends), and/or (v) anti-dilution protection triggered by subsequent issuances by the corporation, usually with certain exceptions, of shares at a price per share that is lower than the price per share they paid for their shares (with the mechanism being a favorable adjustment to the price at which their preferred shares convert to common).

b. Section 305.

Code Section 305(a) provides generally that a stock distribution by a corporation is not taxable to the recipient.  Section 305(b), however, provides exceptions to the general rule.  Any distribution that falls within one of the Section 305(b) exceptions is treated as a distribution to which Section 301 applies (so that the value of the distributed stock is taxable to the recipient to the extent of the corporation’s current or accumulated earnings and profits).

1. Redemption premium/accruing dividends.  Code Section 305(b)(4) provides that stock distributions on preferred stock are taxable.  Among other things, Section 305(b)(4) and the Regulations thereunder require a holder of preferred stock that is redeemable by the issuing corporation or puttable by the holder to the corporation (that is, which the holder has a right to have redeemed) to accrue the “redemption premium” on the preferred stock (the amount payable on redemption of the stock over the amount paid to the corporation for the stock) as if it were original issue discount (to the extent of the corporation’s current or accumulated earnings and profits).  Thus, a holder’s right to have his or her preferred stock redeemed at a price that includes accrued but unpaid dividends may require the holder to report the dividends as they accrue.  Fortunately, under Regulations Section 1.305-5(a), if the holder’s stock participates in the corporation’s growth to any significant extent, the stock is not “preferred stock” for purposes of Section 305(b)(4).¹⁶

2. Change in conversion ratio.  Code Section 305(c) and Section 1.305-7 of the Regulations provide that a change in the ratio at which convertible preferred stock converts to common may be deemed a distribution of stock.¹⁷  Such a deemed distribution is taxable if it has a result described in one of the Section 305(b) exceptions.  Under Section 305(b)(2), a distribution is taxable if it (or a series of distributions of which it is a part) results in (i) the receipt of money or other property by some shareholders (in a distribution to which Section 301 applies) and (ii) an increase in the proportionate interests of other shareholders in the assets or earnings and profits of the corporation.  Distributions are related for purposes of the rule if they occur within 36 months of each other or if they are part of a plan.  Fortunately, bona fide reasonable adjustments to prevent dilution do not cause deemed distributions of stock for purposes of the rule.

3. Conversion.  The actual conversion of preferred to common is generally treated as a non-taxable recapitalization under Code Section 368(a)(1)(E).¹⁸  Under Sections 1.305-7(c) and 1.368-2(e) of the Regulations, however, a recapitalization can result in a deemed distribution for purposes of Section 305 if (i) it is part of a plan to periodically increase a shareholder’s proportionate interest in the corporation’s assets or earnings and profits or (ii) a shareholder owning preferred stock with dividends in arrears exchanges the preferred stock for other stock and thereby increases his or her proportionate interest in the corporation’s assets or earnings and profits (with the deemed distribution being equal to the lesser of (a) the amount by which the greater of the fair market value or the liquidation preference of the stock received in the exchange exceeds the issue price of the stock surrendered in the exchange or (b) the amount of the dividends in arrears).¹⁹

IV. Warrants.

Investors sometimes acquire options (often referred to as “warrants”) to purchase additional shares or other units of equity in connection with their investments.

a. Corporations.

Typically, a warrant issued to an investor in a corporation entitles the investor to purchase additional shares of whatever class of stock he or she purchased (at the same price per share he or she paid for the stock he or she purchased) for some specified period of time, and with the benefit of anti-dilution adjustments.  Investor warrants (as opposed to compensatory options granted to service providers) generally do not present tax issues (and are not governed by Code Section 83), although (i) an amount of the price purportedly paid by the investor for the accompanying stock equal to the value of the warrant can be allocated away from the stock and treated as having been paid for the warrant (for basis allocation purposes), (ii) the investor’s holding period under Code Section 1223 for stock acquired by exercising the warrant does not begin until the investor exercises the warrant (so that the investor may prefer to ultimately sell the warrant rather than exercise the warrant and sell the stock), (iii) a warrant can result in the investor’s being deemed to own the underlying stock if the exercise price of the warrant upon its issuance is too low in relation to the then value of the stock (see Rev. Rul. 82-150, 1982-2 CB 110), (iv) warrants are treated as stock for purposes of Code Section 305 (so that, for example, a change in the exercise price of the warrant outside of the “reasonable antidilution adjustment” exception might result in the holder’s having received a taxable stock distribution), and (v) if the corporation is an S corporation, care needs to be taken to ensure that the warrant does not create a second class of stock.²⁰ 

b. LLCs.

Final Regulations regarding noncompensatory partnership options and convertible debt (under, among others, Code Sections 704, 706 and 721) were published in 2013.  Under the Regulations, with certain exceptions, neither the issuance nor the exercise of a noncompensatory partnership option is a taxable event for the holder of the option, the partnership or the other partners.²¹  Upon the exercise of a noncompensatory partnership option, the holder’s capital account is credited with the amount he or she paid to acquire and exercise the option (including the fair market value of any property he or she contributed to exercise the option).  The partnership’s properties are to be revalued as of the time immediately after the exercise, and the unrealized income, gain, loss and deduction is to be allocated first to the capital account of the exercising holder to the extent necessary to reflect his or her right to share in partnership capital and thereafter to the capital accounts of the historic partners to reflect the manner in which they would share in the proceeds of a taxable disposition of the partnership’s property at fair market value.  Disparities between the partners’ bases and capital accounts are to be eliminated under Section 704(c) as the partnership’s properties are depreciated, amortized or sold.  If the exercising holder’s capital account still does not reflect his or her right to share in partnership capital after the allocations of unrealized income, gain, loss and deduction, the partnership is to reallocate capital to the exercising holder from the historic partners and make “corrective” allocations of gross income and gain or gross loss and deduction among the partners for tax purposes corresponding to the shift in capital.²²

V. Valuation and Related Issues.

A key term to be negotiated with an investor is the valuation to be placed on the entity receiving the investment.  The valuation generally determines the percentage interest in the entity to be acquired by the investor and therefore the number of shares (or other units of equity) issued to, and the price per share (or other unit of equity) paid by, the investor.²³

a. Equity Awards to Service Providers.

1. Corporations.  Equity awards by corporations to service providers generally take the form of options or restricted stock.  In either case, the value of the underlying stock at the time of the award is a key factor in determining the consequences of the award.  If the award is in the form of an option, the exercise price of the option must be at least equal to the fair market value of the underlying stock as of the date of the grant of the option for the option to be an incentive stock option (or “ISO”) under Code Section 422 and to avoid the applicability of Code Section 409A.  If the award is in the form of restricted stock, any excess of the value of the stock over the amount paid for the stock is compensation income for the year of the award if the award recipient makes an election with respect to the stock under Code Section 83(b).²⁴  In any event, the price paid for stock by an investor is a “data point” for purposes of valuing equity awards made by the corporation.²⁵

A. “Cheap stock.”  The term “cheap stock” is sometimes used to refer to stock issued by a corporation to a service provider that might, when viewed in conjunction with a contemporaneous issuance of stock by the corporation to an investor for cash, have a value greater than the amount of any money and the value of any property contributed by the service provider for the stock (so that all or some portion of the stock may have been issued to the service provider for services).  For example, suppose (i) that a founder forms a corporation and, upon the formation of the corporation, receives 80 shares of the corporation’s stock, and (ii) that contemporaneously with the formation of the corporation, an investor purchases 20 shares of stock in the corporation for $200,000.  The price contemporaneously paid by the investor may imply a value of the founder’s shares of $800,000 (or even more if the founder’s shares have some sort of control premium).  To the extent the founder has received his or her shares for services, he or she has $10,000 (or more if there is a control premium) per share of ordinary compensation income to report.  To avoid a “cheap stock” problem, founders should consider (i) forming their corporations well in advance of investments in the corporations, (ii) contributing as much property as they can under the circumstances for their shares (and fully documenting their property contributions so as to attribute as much value to their property contributions as possible under the circumstances), and (iii) if their corporations are C corporations, causing the corporations to issue common shares to them and preferred shares to investors so that discounts can apply in valuing their common shares.

2. LLCs.  Equity interests awarded by LLCs to service providers are often structured so that they may qualify as “profits interests.”²⁶  A profits interest is an interest that would entitle the holder to receive nothing if the LLC sold its assets for an amount of cash equal to their fair market value and liquidated immediately after the issuance of the interest.  In general, a service provider is not taxable upon his or her receipt of, or vesting in, a profits interest.²⁷  To qualify an interest awarded to a service provider as a profits interest, it is generally necessary to carve the LLC’s existing liquidation value off for the benefit of the other members.  If, in the example in IV.a.1.A. above, the corporation were instead an LLC and the founder’s interest were intended to be a profits interest, the LLC’s operating agreement should provide the investor with a right to receive the first $200,000 of liquidation proceeds.²⁸

b. LLC Book Adjustments.

An investment in an LLC is an event that allows for the restatement of the book values of the LLC’s assets (to fair market) and the members’ capital accounts (to the amounts they would receive in a liquidating distribution under the operating agreement if the LLC then sold its assets at fair market value) under the Section 704(b) Regulations.  Code Section 704(c) and the regulations thereunder then apply (in “reverse” fashion) with the objective of eliminating disparities between the members’ tax bases and capital account balances resulting from the revaluation.

VI. Founder Vesting.

Investors may require that some or all of the outstanding shares held by founders and other service providers be made subject to vesting.  Before the issuance of Rev. Rul. 2007-49, 2007-2 CB 237, it was thought that the imposition of a vesting requirement with respect to outstanding shares might constitute a constructive exchange of unrestricted shares for restricted shares, thereby requiring the filing of a Section 83(b) election to avoid adverse consequences to the holder of the shares upon vesting.  Rev. Rul. 2007-49 clarified that the imposition of a vesting requirement with respect to outstanding vested shares does not constitute a “transfer” of unvested shares to the holder for purposes of Section 83, so that a Section 83(b) election need not be made to avoid a tax event upon vesting.  Of course, there may be circumstances under which outstanding shares were issued with the understanding that they would be subject to a vesting requirement (so that issuing the shares and then subjecting them to a pre-negotiated vesting requirement might not bring the shares within the facts of Rev. Rul. 2007-49).

VII. Debt Financings.²⁹ 

Companies sometimes receive investor financing in the form of debt.  Debt, particularly debt with equity-like features (such as contingent interest and convertibility), can raise a number of tax issues, including (i) whether an instrument that purports to be debt is debt or equity, (ii) interest deductibility,³⁰ (iii) the applicability of the original issue discount rules, (iv) the consequences of converting or cancelling the debt,³¹ (v) the consequences of modifying the debt,³² (vi) the consequences of the assumption of the debt by an entity into which the issuer converts, and (vii) the applicability of Code Section 305 to corporate convertible debt.