Avoiding the Apocalypse: Tax-Planning Basics for Startups

I've spent a ton of time lately on startup organizations, which I suppose is another great sign of the most recent end of the most recent tech apocalypse. In fact, there have been slightly more misplaced "end is nigh" predictions in our business, especially in Canada, than in the raft of recent Mayan calendar-inspired Hollywood offerings (one of which my wife and I endured, and I mean endured, last night - like really, how many active volcanoes can John Cusack leap with a relatively ill-equipped recreational vehicle?).

In any event, all these warm and fuzzy thoughts of recovery have inspired me to cover a few tax-planning thumbnails for founders thinking about finalizing their companies' share capital structures. Here are my thoughts, brief and disclaimer-free enough to send our tax lawyers Dineen Beath and Estelle Duez screaming down the hall this afternoon with two fistfuls each of qualifications (each of Dineen and Estelle are outstanding by the way, and I'd be happy to frighten them in person with my treatment of your startup's issues anytime).

Structure Before Success: Here is the basic guideline all founders need to follow: option grants/share issuances at fair market value = good tax result, and option grants/share issuances at less than fair market value = bad tax result. As a result, you should complete all of your sweat equity structuring before your company gets valued (usually, through a financing). Once you create a defensible value in the company, you create a bunch of tax issues for the founders, employees, directors and consultants getting free or near-free shares in your company.

Get the $750K Clock Ticking: Shareholders of most startups in Canada get the benefit of the $750,000 capital gains exemption upon the sale of the shares. One of the conditions to getting the benefit, though, is that the shareholders must have owned the shares for at least 2 years. As a result, get stock in your founder group's hands as soon as possible to give them a fighting chance to get this benefit. This usually means choosing restricted stock (which is issued up front) rather than stock options (the right to purchase shares in the future) as the instrument of choice. Address any vesting requirements with contractual repurchase rights (typically, with any unvested shares repurchased for nominal consideration). If you want to retain control over the shares, get a voting trust or power of attorney from the affected shareholders. Providing you get this done before you've created real value in the company, you won't cause any near term tax obligations to any of the affected shareholders.

You Don't Need a Mini-Van to Have a Family Trust: Holding founder shares through a family trust is a great, legitimate tool for multiplying the number of $750K capital gains exemptions available to protect future exit proceeds from tax. Properly structured, the founders can totally and absolutely control both the voting rights of the shares held by the trust, as well as decide where the proceeds go on exit. They are cheap to set up, and hey, just because you have a family trust doesn't mean you have to leave your bachelor/ette lifestyle behind, sell the loft and move to Aurora or Kanata to the house with the white picket fence - they work for everyone.

The TaxMan (Heart) Employees: Last thing, you can't really screw up from a tax perspective in giving shares or options to employees of your startup, even if you blow the basic guideline set forth above. The Canadian taxman won't tax Canadian employees, directors or officers (like a CEO or CFO) until they actually sell the shares that they hold in the startup. This isn't true for consultants. If these guys get free stock after the company has been valued, or if you paying the fees payable under a development or other contract in shares, those guys are going to have to pay tax on benefit right away, even though the shares that they hold may not be sold for many years later.

As you can probably tell, this is the one area of startup law, like the plotline of 2012, that doesn't always add up. But if you do need someone to reach out of a moving airplane to pull you in, or reach over an earthquake-inspired crack in the earth to pull you to solid ground, consult a early stage company-savvy corporate or tax lawyer (like us) and we'll get you on the Ark to safety.