The IPO market continues to be quite hot. Antsy entrepreneurs who have been busy expanding their companies are asking: Is now the time to go public and take advantage of this robust market? Although there are many nontax considerations when it comes to an IPO, this article will focus on tax questions and actions the corporation, the shareholders, and the employees should consider before pulling the trigger to go public.
The main corporate considerations revolve around investor and SEC tax reporting readiness.
- Are the company's taxes accurate dating back to the beginning of the company? Once a company is public, the tax numbers must be materially correct. Any subsequent adjustment to the numbers may cause a restatement of the financials, which almost always results in a drop in the stock price.
- Are the company's tax internal controls sufficient to capture any potential errors before they happen? Before going public, most company treat tax as an "after the fact" event to be accounted for after year end. Public companies are required to contemporaneously assess tax risks and put controls in place to discover tax problems before they occur. The process of putting in appropriate controls can be expensive and time-consuming.
- Can the company project its effective tax rate and meet those forecasts quarterly? Companies often give future guidance to investors on various financial statement items, including projected effective tax rate calculations. Pre-IPO nonpublic companies enjoy the benefit of not having to go through this exercise quarterly.
Shareholders are most interested in maximizing the value of their investment. Although only controlling shareholders have much influence on the timing of when a company goes public, all shareholders can plan what to do with their corporate shares.
- Do I sell the shares in the offering or wait? This question has a variety of nontax considerations. Will the price go higher after going public? Or will the stock be so thinly traded that my ability to sell a large block be limited? The tax angle involves the shareholders' tax position. Are there capital losses available to offset any gain?
- When should I gift or transfer shares to trust? Shareholders should evaluate estate and gift opportunities long before an IPO event. Usually gifts and trust transfers made far in advance of an IPO attract a lower valuation for gift and trust tax reporting purposes.
Savvy entrepreneurs reward employees, especially key employees, with incentive and nonqualified stock options. These equity awards to key employees attempt to ensure that their interests are aligned with shareholders' in maximizing value. Employees should ask themselves the following questions.
- Should I exercise nonqualified stock options before the company goes public? For tax purposes, when a nonqualified stock option is exercised, the difference between the fair market value of the stock and the exercise price is considered taxable income, subject to an immediate withholding tax. In a pre-IPO situation, the employee has to come "out of pocket" not only for the exercise price of the option but also for the withholding tax. Once the company is public, the employee has liquidity to sell the some of the shares to pay the exercise price and withholding tax.
- Should I exercise the incentive stock options before the company goes public? Incentive stock options are afforded favorable tax treatment upon exercise. If the incentive stock options meet the criteria of Internal Revenue Code Section 422, then upon exercise, the difference between fair market value and the exercise price is not included in taxable income for regular tax purposes and not subject to withholding tax. Employees should be aware that the transaction may be subject to alternative minimum tax.
The advantage of exercising the stock options (either incentive or nonqualified) before the company goes public is that the employee begins the stock capital gain holding period. If the individual meets the holding period requirements (usually one year from the date of exercise), all subsequent appreciation is taxed at the lower capital gain tax rates.
Company executives, shareholders, and employees should identify and focus on better understanding risks and opportunities. The best time to do this analysis is like voting in Chicago. Do it early and often!