Proactive tax planning ahead of your technology or life science company’s transaction can help enhance investor value by addressing complex issues and improving outcomes.
Strategically prepare for transactions within these industries by exploring the following actions and their possible benefits:
- Negotiate value for net operating losses and research credits
- Protect incentives to employees
- Provide an increased after-tax value to investors through gain exclusion
- Reduce tax impact with transaction costs
Transaction Planning Overview
With large investments required upfront for R&D, companies often look toward a transaction whether that be a significant round of financing, or an exit through sale or initial public offering (IPO). There are several tax issues that can catch you unaware in a transaction if these considerations aren’t planned for ahead of time.
Alternatively, effective tax planning can help provide additional value to investors. While effective tax due diligence and tax structuring can help a company upon a transaction, there are also several other common but complex tax issues that can affect the transaction.
Negotiate Value for Net Operating Losses and Research Credits
Due to the upfront investment in R&D, technology and life science companies often accumulate a large amount of tax attributes, such as net operating losses (NOLs) and research credits that carry forward and can potentially offset tax once taxable income is generated. Often, these companies don’t generate taxable income to realize this benefit until after a transaction or large financing round.
When this happens, these attributes may be limited by Internal Revenue Code (IRC) Sections 382 and 383, which limit the amount of attributes that can be used to offset taxable income or tax after an ownership change—generally, a greater than 50% shift in ownership, though the rules are complex.
When there are multiple ownership changes (for example, the result of multiple preferred financing rounds), it can create pools of attributes that are subject to different limitations, and the smallest limitation will apply.
It’s therefore important that prior to a transaction, the company perform an IRC Section 382 and 383 analyses to negotiate value or additional purchase price with a buyer. To the extent no analysis has been completed, buyers will usually attribute no value to the NOLs or credits as it is uncertain how much value those attributes may have.
Protect Incentives to Key Employees
In a competitive market like that of technology and life sciences, it’s an important part of any company’s business strategy to be able to attract and retain talented executives and key employees. These executives may also be the founders of the company.
It’s common for this compensation to be tied to performance and driving results through equity compensation such as stock options or restricted stock. There are often key incentives that may be tied to a successful closing of a transaction such as a transaction bonus or an acceleration of the vesting on equity awards.
These payments can be subject to IRC Section 280G, which can result in some very negative consequences including a 20% excise tax to the individual recipient (in addition to regular federal and state income tax) and the loss of a deduction to the company. This can be detrimental to the company not only in the tax impact of the lost deduction but in the lost goodwill toward those key employees.
It also can be an issue that may hold up or kill a deal if the parties can’t agree on approach in dealing with the issue. Thus, it’s important to plan for the potential impact ideally when drafting employment agreements or compensation arrangements and prior to leading into a transaction.
Provide an Increased After-Tax Value to Investors Through Gain Exclusion
Every dollar of decreased tax to an investor increases the net value of that benefit to them. To the extent a company and the shareholders can meet the requirements to be considered qualified small business stock (QSBS) under IRC Section 1202, the shareholder can exclude part or all of the gain (depending on when purchased) on the sale of that stock from federal income tax.
Some requirements apply at the company level and some (such as holding the stock for five years) apply at the shareholder level. To the extent a company can document and analyze to represent to investors that the company level requirements have been met, the shareholders can then work with their individual tax advisors to ensure the benefit is allowed.
Some key requirements at the company level include the following:
- The stock was issued from a C corporation in an original issuance (and the date issued determines the percentage of gain exclusion).
- The stock must be in a qualified industry.
- At least 80% of the value of the corporation’s assets must be used in the conduct of an active business.
- Immediately after the stock issuance, the corporation had less than $50 million of aggregate gross assets.
Each of these requirements has their own nuanced complexities to be carefully considered with the company’s tax advisor.
Reduce Tax Impact with Transaction Costs
Most transactions result in incurring significant amounts of transaction costs such as legal fees, due diligence, structuring, and investment banker fees. The tax law allows certain of these costs to be deducted while others may have to be capitalized.
When these fees are capitalized to the stock, the tax benefit may not be able to be realized for an extended or indefinite period. It’s important to get ahead of obtaining documentation and analyzing these costs while going through a transaction as often the proper documentation may be difficult to obtain from service providers as time passes after the transaction.
We’re Here to Help
If you have questions about planning transactions within the technology and life sciences sectors, please contact your Moss Adams professional.