Why You May Pay 75% Income Tax When You Sell Your Company — And How to Avoid It

[EDIT] This post was removed because it had a link to my Substack which I didn’t realize was against the rules, so I am reposting with the link removed.

I am helping a friend start up a biotech company that will produce low-cost cancer drugs for Africa. I’ve been helping him with his business plan, pitches, recruitment, and a host of other things, but one thing that wasn’t on his list was tax planning. I told him that I knew many people who sold their company but ended up giving 75% of their payday to Uncle Sam because they didn’t realize how taxes work with startups.

The thing is, you have to set things up right with taxes when you start the company, not when you sell it.

Now, I must caveat this by saying I believe in paying fair share of taxes. When my financial planner suggested using multiple trusts to multiply QSBS exemption, I refused, because it seems almost like an abuse of the laws to do that. However, I feel like 75% is a bit more than a fair share?

I must also caveat this by saying that this is not legal advice. I did go to law school, but I am not a licensed attorney. Please consult your own lawyer!

First, let’s examine why people end up paying 75% in taxes. To achieve this goal, you should carefully follow these steps:

Take your equity in options instead of restricted shares, and don’t exercise the options until you sell the company. Your payout on close of the sale will then be treated as ordinary income rather than capital gains.
If you get restricted shares, don’t file an 83(b). This is also a good way to get taxed on your payout as ordinary income.
Make sure you live in California, to maximize state tax.
Qualify for 20% excise tax (Section 280G tax) by being a) officer, b) 1%+ shareholder, or c) one of the top 1% compensated employees in the company; and getting a payout that is more than 3 times your base pay
Make sure you don’t have a 280G gross-up clause in your employment contract (these clauses are now rare in public companies, shareholders hate them)

If you do all the above, then congratulations, you get to pay about 75% of your payout in taxes. https://www.alvarezandmarsal.com/insights/280g-golden-parachute-payments-primer

(The above is a simplification, it’s complicated, the M&A law firms have lawyers who do nothing except 280G calculations.)So… don’t get into that situation please.

Second, let’s talk about QSBS, or Qualified Small Business Stock deduction. https://frostbrowntodd.com/a-section-1202-walkthrough-the-qualified-small-business-stock-gain-exclusion/ The rules have a lot of conditions and exclusions but in most cases, if you invest in a startup that’s valued less than $50 million, and hold for at least 5 years, then the first $10 million of gain is free of federal taxes. And unless you live in California, it’s usually free of state taxes too. Pretty good, huh?

Wait, there’s more. In addition to the $10 million exclusion for yourself, any tax paying entity also gets $10 million exclusion. So if you set up a trust for your spouse, and she sets up a trust for you, etc. each trust gets an exemption — according to my planners. As I wrote above, I think doing that seems a bit not quite kosher morally so I wouldn’t go too far with it… or else you might get written up in the NY Times. https://www.nytimes.com/2021/12/28/business/tax-break-qualified-small-business-stock.html

Now please note that you must BUY your shares. It can’t be just awarded to you. You must purchase them. So get out your checkbook and make sure you write that check for $200 for your Founders Shares.

Third, let’s talk about Roth IRAs. If you set up a self-directed Roth IRA, you can purchase shares in your company into the IRA. All your earnings in that account are tax-free. https://www.svb.com/private-bank/insights/wealth-insights/founder-strategies-purchasing-company-shares-for-your-retirement-account You can’t withdraw money from that account until you’re old unless you pay a penalty of course, but you can borrow against it.

There are a LOT of rules around this (including disqualification of company officers) so please consult a lawyer. And once again, let’s not abuse it, eh? If you end up with $5 billion in your Roth you get to be written up on ProPublica like Peter Thiel. https://www.propublica.org/article/lord-of-the-roths-how-tech-mogul-peter-thiel-turned-a-retirement-account-for-the-middle-class-into-a-5-billion-dollar-tax-free-piggy-bank

Fourth, donate. If you have Founders Shares or other shares with low cost basis, for every $6 you donate to a charity, you get $5 back from the government. (Once again, this is if you’re in California. You may get a bit less back if you’re in other states because poor you, you don’t get to pay as much in state taxes.) This is because you get to deduct the full value of your donation, even though you have never paid tax on the value of the shares. You double your deduction. https://www.cbsnews.com/news/donating-appreciated-stock-a-double-play-of-tax-benefits/

Once again, lot of rules (e.g. the stock needs to be have been held for at least a year), so talk to your lawyer, but one thing you need to know: once it becomes a certainty that your company will be sold, IRS considers the donation to be in cash not in stock so you don’t get the double deduction. This is the case even if the transaction has not closed yet. https://frostbrowntodd.com/section-1202-planning-when-might-the-assignment-of-income-doctrine-apply-to-a-gift-of-qsbs/ So you have to donate before that happens. Also important is that you usually need to get an independent appraisal for your shares if the company is private.

If you’re selling a public company, though, make sure it’s written into the M&A agreement that you’re allowed to donate stock. If you don’t, you may be locked into holding the stock until the close.

The simplest way to donate is into a donor advised fund, especially one like Silicon Valley Community Foundation that knows how to accept restricted shares, because many charities won’t be able to accept them. Private Foundations can take a long time to get IRS approval so you probably won’t have time to set one up.

Once again, please note, this is NOT legal advice. (These are just things I have learned. I hope you have a chance to put these tips to good use.) So, let me repeat, talk to your lawyer!