In IPO pre-planning, entrepreneurs need to take stock

23 Jun In IPO pre-planning, entrepreneurs need to take stock

Madison, Wis. – We have looked at several types of equity compensation in our last few columns. Generally, the hope is always the same: if the company succeeds, the equity compensation holders will get to share in that success. Sounds easy, right?
Not so fast. If you hold stock options and have not thought about how they might affect you until the moment of the company’s IPO or sale (or, worse, AFTER the IPO or sale), you will have lost a golden opportunity to plan.
For this column, I’ve asked a business associate of mine to take us through some basic guidelines to prepare for that day. Chris Burque is a Wealth Management Advisor in the Madison office of Merrill Lynch, specializing in preparing equity compensation holders for IPOs. I’ve asked him to give us all some guidance in how to prepare.
In pre-IPO planning, you should consider three major areas: providing for your family or heirs, minimizing estate taxes, and minimizing income taxes.
Providing for family
To provide for your family, heirs or beneficiaries, start transferring your wealth – even your future wealth – today. By transferring options before the IPO or merger increases the value, you’ll minimize gift taxes and maximize the wealth passed on to those you want to be comfortable. There are many ways to accomplish this transfer without giving up control or spoiling the recipients of your gifts. Some of the most common and accepted methods are family limited partnerships and grantor retained annuity trusts.
Family limited partnerships (FLPs) act as a comingled investment vehicle for your family. With an FLP, you can transfer wealth to the next generation while retaining control over the asset. In addition, valuation discounts may reduce transfer taxes, and you may be able to divide illiquid assets (such as real estate) into units for gifting. However, you should work with an experienced advisor to ensure that your FLP is properly designed to meet Internal Revenue Service tests, and an FLP may have additional accounting and administrative costs.
Where significant appreciation is expected, grantor retained annuity trusts allow you to transfer future growth to a beneficiary with little or no tax, while the trust pays back to the grantor (creator of the trust) an annuity stream. This annuity can be in cash or in the stock that was gifted to the trust. If the trust pays the annuity with the contributed securities, it may be possible for the grantor to avoid income tax consequences.
With the right planning in place, you may be able to take advantage of these planning techniques with your stock option rights.
Minimize taxes
We all know too well that life is fleeting, and so does the IRS. Estate taxes are onerous, and you have the choice to direct your fortune to those you love and to philanthropic projects that you admire. At this stage, you can set up trusts to be used after the explosion of growth, such as family foundations, charitable remainder trusts, charitable lead trusts, and life insurance trusts.
You might also be able to use valuation discounts to leverage these transfers. Valuation discounts can be thought of in the following ways: a large block discount reflecting the market impact of selling a large block of stock; minority and non-controlling interests in closely held corporations or partnerships; and restrictions on disposition. After the IPO or merger, using valuation discounts will be much more difficult.
Minimize income taxes
With success often comes increased income. This income comes not only in the form of a paycheck, but also from a variety of compensation awards, such as employee stock options and restricted stock grants. The Internal Revenue Code states that if you receive restricted stock as compensation, you will not be subject to federal income tax until the restriction lapses.
In most cases, the value of the stock rises when any restriction on transfer ceases. If you receive restricted stock and it is subject to a substantial risk of forfeiture, then under IRC Section 83(b) you can elect to be taxed on the value of the restricted stock at the time you receive the stock, rather than on the higher unrestricted value, potentially saving you significant tax dollars.
However, under IRS guidelines, you have only 30 days upon receipt of the restricted stock to make this election. As we have discussed in earlier columns, the opportunity to plan is gone after a limited amount of time, so working with your advisors earlier is always better.
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