Resources > Articles by Joe Hadzima

Beware Capital-Gains Gift - New Companies Should Take Care

By Joe Hadzima, Partner and Co-director of High Tech/New Venture Group, Sullivan & Worcester, jgh@alum.mit.edu

Comments are welcome!

---

An MIT professor and one of his post-doctoral students came to see me the other day. They wanted to discuss starting a business venture that would exploit a new technology for building inexpensive high-density semiconductor chips.

"Of course," said professor "Tim," "we'll want to take advantage of the gift Uncle Sam gave us last summer, that new reduced capital gains provision for small businesses under the recently passed Tax Act."

"Hold on, Professor" I said. "That gift could very easily turn out to be a Trojan horse for ventures such as yours."

I could understand why he was calling the new tax law a gift. The new code declares that, if you invest in a small business (i.e., under $50 million in gross assets) after Aug. 10, 1993, and you hold your stock for at least five years, then half of any capital gain you realize down the road will be excluded in determining the tax you owe when you sell that stock.

In effect, the investor incurs only a 14 percent tax rate on the gain (i.e., 28 percent capital gains rate applied to one-half of the gain). The amount of gain that can be excluded is equal to the greater of 10 times your investment, or $10 million. Sounds good, right?

Hold on. One half of the excluded gain is taken into account in calculating the alternative minimum tax (AMT), which would boost the professor's tax rate to about 21 percent if his new venture is a big hit. (If the company hits a home run, it's extremely likely that the AMT will kick in, and the effective tax rate will be 21 percent instead of 14-that way, Congress can advertise that the rate is 14 percent on the capital gains when, in effect, they'll almost certainly get an additional 7 percent through the back door.)

"Well," said Professor Tim, "21 percent is still better than the usual and customary 28 percent capital-gains tax. Let's go for it!"

"Unfortunately, it's not that simple, Professor," I said.

In fact, the new provision could end up costing him much more than 28 percent in taxes. The reason? In order to qualify for Uncle Sam's "gift," the professor's company would have to be a C corporation - in other words, a corporation that is required to pay tax.

"You mean there are corporations that don't pay taxes?" asked Professor Tim.

"Better believe it," I said. "They're called S corporations."

I could see it was time for a real-life fable, so I decided to tell Professor Tim about another MIT spinoff venture started by one of my MIT/Sloan School of Management students.

Two years ago that student-"John"-came to me to start a new venture in the multimedia area. It's important to note that John's business plan figured on funding his start-up company's rapid growth with financing from venture-capital investors. Because initially the company qualified to be an S corporation, I recommended that John file an election with the IRS to be taxed as an S corporation. (For simplicity's sake, an S corporation is one that has fewer than 35 stockholders, all of whom must be human beings who are residents of the U.S. or certain trusts, and only one class of stock).

By electing S corporation status, as I was recommending, John's corporation would not pay federal taxes on any income or gain; taxes would be paid by the stockholders instead, thus resulting in only one layer of tax. C corporations, on the other hand, to pay tax, and the stockholders of C corporations also pay tax when they receive dividends, etc.

"No way," John told me. "I know I'll get the venture capital backing. So it'll be a waste of time and money to elect S corporation status."

I explained that taking on venture-capital investors usually results in a corporation losing its qualifications as an S corporation-because traditional venture capital firms are partnerships or corporations, which are not eligible shareholders of an S corporation. Fortunately, I was able to persuade John to file the S corporation election, which he did two years ago.

To be sure, John came very close to getting venture-capital financing but, in the end, like many entrepreneurs, he was forced instead to use creative "bootstrapping" techniques to fund and grow his company, and launched his first product about a year ago to rave reviews.

Last spring, for strategic reasons, John decided to sell his company to a larger public company that had complementary product offerings at the higher end of the market in which John's product sold. The sale was structured as a purchase of assets, and John and his stockholders (who were family and friends) received $4 million for their $250,000 investment.

Because John's corporation was still an S corporation, he and his stockholders avoided a 35 percent tax at the corporate level on the sale of assets, resulting in a tax savings of approximately $1 million over the result had it been a C corporation.

After hearing the story about John's company, Professor Tim is thinking this one over and will probably elect to have his company taxed as an S corporation.

"To hell with Uncle Sam's gift!" said Professor Tim.

Is the new small-business capital gains exclusion provision useless? Not at all. But, it may not make much sense for a new venture facing rapid technological change in its product markets where a likely exit strategy is a sale before the end of the five-year holding period required for the exclusion. Five years is a very long time, and there is the risk that Congress could modify or repeal the provisions with an adverse result for Professor Tim's company.

Does this mean that all new ventures should elect to be taxed as S corporations? Certainly not.

Although S corporations do not pay tax on corporate income, the stockholders of S corporations do. Under the Clinton tax act, the top individual tax rates approach 45 percent, while the top corporate rate is 35 percent. If the corporation is generating profits, those profits will be potentially taxed at a greater rate if the corporation is an S corporation.

However, if-as in John's case-the inherent value of the business is likely to be significant, then the entrepreneur must consider whether paying tax on current profits at a potentially higher stockholder tax rate is worth doing in order to avoid a large corporate-level tax on sale of the business.

The point is that every business situation is unique, and there are no standard "cookbook" solutions to all situations.

The good news is that there are often ways to work with or around the limitations of any tax code. Never assume, as Professor Tim did, that just because Uncle Sam really want to help small business, that the manner in which Congress does it will actually help you.

In the case of the new tax act, it most certainly pays to look the gift horse in the mouth!

Copyright © 1994, Boston Business Journal

---

Joseph G. Hadzima, Jr. is a partner at the Boston-based corporate law firm Sullivan & Worcester, where he heads the High Technology/New Ventures Group. He is also a Visiting Faculty member at the MIT Sloan School of Management. Telephone: 617-338-2866, Fax: 617-338-2880, Internet: jgh@alum.mit.edu.