Venture Capital Fund Tax Planning for Advisory Shares
February 24, 2023
By Kayla Konovitch and Richard Cleaveland
With the economy seemingly slated for a soft landing, venture capital and private equity-backed portfolio companies will need to navigate the challenges by leaning more heavily on the expertise and networks of their sponsors. Early-stage companies have a long history of leveraging this expertise given their lean operating structures and incomplete management teams. The cumulative experience of investment teams and operating partners will be instrumental in helping those companies. They will assist in modifying operating forecasts for longer sales cycles and higher costs along with evaluating for optimal levels of resources and opportunities for corporate transactions.
Especially in an environment where conserving cash is crucial, those companies and their sponsors may look to structure the compensation for this additional assistance as awards of advisory shares, or as stock-based compensation.
But who should receive that compensation and in what form should it be paid? The investment management team already receives a management fee and carried interest from the fund for their services in identifying, advising on and monetizing investments, so incremental income from that work typically should accrue to the fund. When cash advisory fees are paid to a sponsor management company, it is usually treated as a management fee offset, in that any cash received would reduce the amount of cash management fee for the year. However, when it comes to noncash compensation, in the form of an ownership interest, it becomes more complex. First, the management company, who already has effectively deferred a large portion of its total compensation through the carried interest, would likely be unwilling to further reduce a cash management fee for the promise of upside return in the future. And second, from the limited partner’s (LP’s) perspective, should they not be entitled to that upside since they have provided the capital for investment and compensation to the management company?
At first glance, granting the advisory shares to the investment fund seems like an effective solution. The investment fund receives additional potential upside. The general partners (GPs) and their employees hopefully share in that upside through the carried interest and do not sacrifice any of the current cash management fee. But there are pitfalls to an investment fund receiving any form of compensation.
From a tax perspective, there are complexities to navigate through and consider when receiving equity compensation for services. It is important to understand the types of equity compensation that can be issued and the tax implications of each. The four most common forms of equity compensation issued to consultants are: 1) non-qualified stock options (NQSOs), 2) restricted stock, 3) restricted stock units (RSUs) and 4) warrants.
Note that we will not discuss incentive stock options (ISOs), as those can only be granted to employees of the company, and not to outside service providers.
NQSOs grant the recipient the right to buy shares of stock within a certain period, at a fixed price (referred to as the strike price), exercise price or grant price. The strike price is generally determined by the company’s IRC Sec. 409A valuation or fair market value (FMV). As the share value increases, you make money on the spread between your fixed purchase price and sale price.
Tax treatment of NQSOs
At the time the NQSO is granted, there is no current taxable event. However, at the time the NQSO is exercised, you will pay tax at ordinary income tax rates, for the difference between the FMV (at the time of exercise) and the grant price. The FMV at exercise becomes your new tax basis going forward. Keep in mind: This generates phantom income, and one should make sure they have cash available to pay tax at the time of exercise. The holding period begins on the date of exercise. In the future, if the shares are held more than a year and subsequently sold, you may receive favorable long-term capital gain treatment on the difference between the sale price and your basis. If shares are held less than a year and subsequently sold, the gain will be taxed at less favorable short-term capital gains tax rates. Note there is no opportunity here to make an IRC Sec. 83(b) election, electing to pay tax on grant rather than when the option is exercised, unless the NQSO has a readily ascertainable FMV (which is virtually impossible for non-publicly traded options). See below for further discussion on IRC Sec. 83(b).
Restricted stock is stock of a company that is subject to transfer limitations until certain conditions are met. The stock usually follows a vesting schedule, receiving partial grants of shares over a period. However, until the stock is vested, the stock is restricted and not saleable. Upon satisfaction of those conditions, the stock is no longer restricted and becomes transferable.
Tax Treatment of Restricted Stock
Restricted stock is not taxable upon grant. As restricted stock vests, it is taxed at ordinary income rates based on the FMV of the shares on the date of vesting. The value of the stock at vesting becomes your tax basis in the shares. Upon sale of the shares, you will receive capital gain treatment on the difference between the sales price and the tax basis in the shares. The holding period begins on the date of vesting. If the shares are held over twelve months, you may receive favorable long-term capital gain treatment.
IRC Sec. 83(b) Election
There is an opportunity for potential tax savings upon the grant of restricted stock, by making an IRC Sec. 83(b) election within 30 days of receiving the stock. This election allows you to pay income tax when you are granted the restricted stock, rather than at the time of vesting, when the value of the shares may be greater. Essentially, you are paying tax at ordinary rates on a nominal value with any subsequent appreciation taxed at lower capital gains tax rates, if the restricted stock is held more than a year from election date. This starts the holding period sooner.
However, this strategy does have some risks. If you make the election and the stock never vests, then you picked up some income for naught and are not entitled to a refund on the tax paid. You will, however, have a capital loss that may be used against capital gains on your tax return subject to limitations for using capital losses. Or, if the shares decline in value over the vesting period, you may overpay taxes. The key is, what is the value at the time of issuance? If no value or minimal value, then this may be the best route to go as there is minimal tax downside.
If an IRC Sec. 83(b) election is NOT made, then there is no tax upon grant of restricted stock. However, once it vests, there is tax on the value of the shares at ordinary tax rates, where the value may have substantially increased since the date of grant. There is also phantom income unless you sell the stock at the same time. However, if the value of the shares has increased from date of initial grant, you are paying more tax at ordinary tax rates than if an IRC Sec. 83(b) election had been made.
RSUs are not actually equity, but more akin to a deferred bonus. It will be treated as deferred compensation under IRC Sec. 409A because no equity or the right to acquire equity has been transferred. It is a promise to pay an amount based on a fixed number of shares on a fixed date in the future and is typically settled in shares of stock or cash.
Tax Treatment of RSUs
RSUs are taxed when they vest, at ordinary income tax rates. Since RSUs are not equity, no IRC Sec. 83(b) election is available.
Warrants are a right to purchase company stock, at a fixed price, within a specific period. If the warrants are issued for services, they are treated like a NQSO discussed above.
General Key Holding Period Considerations for all Equity Compensation Offerings
- There are a few holding period considerations that equity compensation offerings need to take into account. The holding period begins on the date of exercise (when you legally own the stock) or on the date an IRC Sec. 83b election is made, if eligible, for determining long-term or short-term capital gain treatment; and
- The holding period begins on date of exercise or on the date an IRC Sec. 83b election is made, for determining the qualified small business stock (QSBS) eligibility and more-than-five-year holding period requirement. For more information on QSBS, see IRC Section 1202 Exclusion of Gain from Qualified Small Business Stock.
Strike price and valuations may be low initially, so there is minimal phantom income generated at ordinary tax rates. The sooner the option is exercised or an IRC Sec. 83b election is made, the more potential there is to benefit from the favorable long-term capital gain treatment and potential QSBS exclusion.
For a more in depth analysis on equity compensation plans and tax treatment, see Tax Overview of Corporate Equity Arrangements.
Other Fund Tax Concerns
If the fund managers intend for investors to share in the upside of the advisory shares, then there are additional tax considerations to consider. As the awards are issued due to services provided, the fund would then be the recipient of the ordinary income and pass it along to its investors.
Here are the potential pitfalls to avoid:
- If the fund has non-U.S. investors and the ordinary income is treated as effectively connected income (ECI) with a U.S. trade or business, the partnership would be required to withhold U.S. taxes on behalf of the foreign investors.
- If the fund has tax-exempt investors and the ordinary income is treated as unrelated business taxable income (UBTI), the tax-exempt partners would be required to pay income taxes.
- In addition, if the fund is in New York City (NYC), NYC may impose a 4% unincorporated business tax (UBT) tax on this income. The issuance of any of these equity arrangements for services taints the income in the fund that would have been exempt from UBT tax.
Venture capital managers may intend for the advisory shares to be held by the fund, to share in the upside with their LPs. This provides for great incentive and potential appreciation and value in their portfolio shared with investors. However, with this potential upside comes a host of tax issues to be navigated and it is recommended that managers discuss the nuances with their tax advisor to plan for the most optimal tax strategy.
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