The Ultimate Tax Guide to Buying and Selling Startup Shares

The substantial financial returns that can result from investing in promising startups early are a major draw for investors and employees alike. The tax environment that surrounds startup share transactions, however, is a notoriously complex one. Trading startup shares presents far more challenges than dealing in publicly traded stocks, as a historic lack of clarity can leave many investors feeling unsure of their tax position. 

When looking at arcane valuation methods to ever-shifting tax regulations, it’s important to examine and understand the tax implications of buying and selling startup shares.

In this article, we’ll look at some effective tax strategies for investors, and explore how innovative platforms like Hiive and Harness can simplify the transaction process, and minimize your tax liability.  

Table of Contents

1. What are startup shares?
2. What are secondary markets?
3. What are the tax implications of buying startup shares?
4. What are the tax implications of selling startup shares?
5. How to trade startup shares effectively
6. Tax planning strategies
7. How platforms like Hiive and Harness can help
8. FAQs

What are startup shares?

Startup shares are an ownership stake in a company before it goes public. While startup shares can offer lucrative opportunities to independent investors, they’re also a key form of equity compensation and a common way to attract and retain talent in these ventures. 

Startup shares come in three main types: 

Common stock: This is the most basic form of ownership, typically held by founders and early employees. It carries voting rights and represents a proportional claim on the company’s assets. However, in the event of a liquidation, common stockholders tend to be the last in line to receive payouts.

Preferred stock: Often issued to venture capitalists and other institutional investors, preferred stock offers preferential treatment. Aside from allowing preferred stockholders to be paid out before common stockholders, preferred stock also carries dividend rights and conversion features. These allow preferred stockholders to transition to‌ potentially less protected but more lucrative positions, if desired.

Stock options: By nature, these aren’t shares themselves but are, instead, the right to purchase shares at a predetermined price (the strike price) within a specific timeframe. As common forms of employee compensation, options come in two main types—Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs)—which we’ll discuss in more depth later. 

Irrespective of the pre-IPO share type received, they’ve traditionally been illiquid assets, with limited ways to realize their value. The emergence of secondary markets, however, has changed this liquidity profile, offering new opportunities for shareholders to trade assets. 

What are secondary markets?

A secondary market, in the context of private company shares, is a platform or network that allows the trading of equity between existing shareholders and potential buyers before a company’s initial public offering (IPO). 

Secondary markets have fundamentally reshaped the private equity arena, offering much-needed liquidity to shareholders in companies that delay or forgo IPOs. This shift has been driven by a number of considerations, including the fact that the average age at which a private company goes public has nearly doubled in recent decades to 11 years. 

As a result, there has been a greater demand for earlier liquidity. Secondary markets allow employees and early investors to realize gains or diversify portfolios, without having to wait for a public offering.

What are the tax implications of buying startup shares?

One of the most common ways that startup shares can be received is as Employee Stock Options (ESOs). They grant employees the right to purchase company shares at a predetermined price, offering potential financial rewards as the company’s value increases. However, the tax implications of ESOs can be complex and vary significantly between the two main types of options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

Incentive Stock Options (ISOs)

ISOs that comply with IRS regulations provide major tax deferral benefits, delaying taxation until the underlying stock is sold. They also offer the opportunity for favorable long-term capital gains tax rates. 

That said, the exercise of ISOs can trigger the Alternative Minimum Tax (AMT)—a separate tax calculation designed to ensure high-income taxpayers pay a minimum level of tax, even if they have significant deductions or credits. This can result in unexpected tax obligations, with careful tax planning required in order to properly manage and optimize tax outcomes.

Non-Qualified Stock Options (NSOs)

NSOs, however, diverge significantly from ISOs in their tax treatment. Upon exercise, NSOs are taxed as ordinary income, meaning the employee immediately owes taxes on the spread between the exercise price and the fair market value. 

This immediate taxation simplifies matters and eliminates any potential complexities and unexpected liabilities associated with the Alternative Minimum Tax (AMT). While NSOs forego the potential for long-term capital gains tax deferral offered by ISOs, their straightforward tax structure provides clarity and predictability, albeit with a potentially higher immediate tax burden.

Direct purchase of shares

Purchasing startup shares directly from founders or early investors requires an accurate determination of the asset’s fair market value (FMV)—with a 409A valuation, conducted by an independent third party, crucial in these circumstances. This valuation not only establishes the shares’ current worth but delivers precise tax reporting and helps prevent IRS scrutiny. 

Angel investing and venture capital

Angel investors and venture capitalists may benefit from Qualified Small Business Stock (QSBS) provisions. QSBS refers to shares of a domestic C corporation (that meet IRS requirements), offering potential capital gains tax exclusions to qualifying investors who hold the stock for at least five years. This allows for the exclusion of a substantial portion of capital gains from federal income tax, potentially delivering major tax savings.

What are the tax implications of selling startup shares?

Selling startup shares triggers distinct tax considerations depending on whether the sale occurs pre-IPO or post-IPO.

Impact of pre-IPO vs. post-IPO sales

Pre-IPO sales involve complicated private transaction rules. These sales often require detailed documentation, including 409A valuations to establish fair market value, and may involve negotiated terms that influence tax implications. These transactions tend to lack the transparency of public market transactions, making accurate reporting and compliance a crucial factor. 

Post-IPO sales, conversely, are more streamlined. Publicly traded shares have readily available market prices, simplifying tax calculations. However, even post-IPO sales require careful tracking of cost basis and holding periods.

Capital gains taxes

The holding period of startup shares significantly impacts tax liabilities. 

• Short-term capital gains—for shares held one year or less—are taxed at ordinary income rates, which can be considerably higher than long-term capital gains rates. 
• Long-term capital gains—applicable to shares held over a year—benefit from preferential tax rates, potentially minimizing tax burdens. 

It should be noted that state tax implications can vary widely. Some states align with federal rates, while others impose their own capital gains taxes, adding complexity to overall tax planning.

Tax reporting requirements

Form 8949 and Schedule D are key tools for reporting capital gains and losses to the IRS. These forms require detailed information, including purchase dates, sale dates, cost basis, and sale proceeds. As mentioned, 409A valuations, particularly for pre-IPO transactions, play a big role in establishing the cost basis and determining accurate gains or losses. In any circumstance, accurate record-keeping is essential to the tax process.

Foreign investor considerations

Non-U.S. residents face further complexities, including withholding tax rules and treaty considerations when selling U.S. startup shares. Withholding taxes may apply to the sale proceeds, and tax treaties between countries can affect the final tax liability. Understanding these rules requires expert guidance, particularly in international tax law, in order to maximize gains. 

How to trade startup shares effectively

Trading startup shares effectively involves a number of variables, including valuation, security, and compliance. While the transaction process has traditionally been complex and troublesome, innovative platforms like Hiive provide a secure and transparent marketplace that addresses the issues commonly associated with pre-IPO share transactions. 

Beyond just providing a trustworthy and transparent stock market for startups, Hiive’s valuation tools are crucial for determining fair market value (FMV), aiding in accurate tax calculations, and ensuring fair and equitable deals. 

Hiive minimizes administrative burdens by streamlining the transaction process, and simplifies the associated paperwork and legal complexities. This efficiency allows buyers and sellers to focus on strategic decisions, rather than getting bogged down in procedural details, ultimately facilitating smoother and more informed trades.

To learn more about Hiive and how their platform can help you trade pre-IPO shares more effectively, you can contact them here.  

Tax planning strategies

The clarity of the transaction data provided by platforms like Hiive, allows investors to trade more confidently. It also allows them to plan tax strategies more effectively. Armed with accurate data, investors can pursue a number of tax strategies that can significantly minimize their tax liability.

Timing of sales

Strategic timing involves carefully considering the holding period of your shares. Holding shares for over a year qualifies them for long-term capital gains rates, which are typically lower than short-term rates.

• Consider market conditions and potential tax law changes when deciding when to sell.
• Consult with a financial advisor to help develop a tailored sales strategy.

Tax-loss harvesting

Tax-loss harvesting involves selling investments that have decreased in value to offset capital gains from other investments. Tax-loss harvesting has the benefit of reducing your overall tax burden by minimizing your net capital gains.

• It’s important to be aware of the “wash-sale” rule, which prevents you from repurchasing the same or substantially similar securities within 30 days of selling them.

QSBS strategy 

As mentioned, Qualified Small Business Stock (QSBS) provisions allow for the exclusion of a significant portion of capital gains from federal income tax. To qualify, the company must meet specific criteria, and the shares must be held for at least five years. Understanding and meeting these requirements can result in major tax savings.

Charitable contributions of appreciated stock

Donating appreciated startup shares to a qualified charity allows you to avoid paying capital gains taxes on the appreciation.

• You may also be able to deduct the fair market value of the donated shares from your taxable income.
• Make sure the charity is a qualified organization to maximize your tax benefits.

Using tax-advantaged accounts

Holding startup shares within tax-advantaged accounts like Roth IRAs or Health Savings Accounts (HSAs) can provide tax-free growth and withdrawals.

• Roth IRAs allow for tax-free withdrawals in retirement, while HSAs offer tax-free withdrawals for qualified medical expenses.
• It should be noted that there are restrictions on what types of assets can be held in these accounts.

Installment sales

If you’re selling a large block of shares, structuring the sale as an installment sale allows you to receive payments over multiple tax years. Installment sales can spread out your tax liability, potentially reducing your overall tax burden. Consult with a tax professional to ensure the installment sale meets IRS requirements.

Using a Grantor Retained Annuity Trust (GRAT)

For high-net-worth individuals, a GRAT can be used to transfer appreciated startup shares to heirs with minimal gift tax implications.

• The grantor retains an annuity for a specified period, with any appreciation above the annuity rate transferred to the heirs.
• Bear in mind that GRATs tend to be complex in nature and require careful planning and execution.

1045 Net Operating Loss (NOL) Carryback

If the sale of startup shares results in a capital loss, you may be able to carry back the loss to offset prior years’ capital gains—and potentially get a tax refund. Understanding the rules for NOL carrybacks and carryforwards is essential.

How platforms like Hiive and Harness can help

As profitable as startup shares can be, the tax complexities involved and the transparency needed for dependable transactions have been long-standing issues. The advent of platforms like Hiive and Harness, however, have transformed the efficiency and dependability of the process. 

Hiive can provide the data clarity required for more informed pre-IPO share transactions, while Harness can deliver the tax expertise needed to make the most of your returns on these transactions. Now, trading startup shares can be easier and more viable than ever. 

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FAQs

Here are the answers to the most frequently asked questions about buying and selling startup shares.

How is my income taxed when I exercise Non-Qualified Stock Options (NSOs)?

Upon exercising NSOs, the difference between the exercise price and the fair market value of the company’s stock is taxed as ordinary income tax.

As an experienced business development employee, how can I best understand the tax implications of my stock options?

It’s vital to consult a qualified tax advisor who specializes in startup equity and employee compensation. They can help you understand the specific tax implications of your options and develop a tax strategy.

When do I pay taxes on Incentive Stock Options (ISOs)?

You typically don’t pay taxes until you sell the shares acquired from exercising ISOs. However, exercising ISOs can trigger the Alternative Minimum Tax (AMT).

How do employee stock purchase plans (ESPPs) affect my taxable income?

Employee stock purchase plans can result in taxable income when you sell the shares, depending on the holding period and the discount offered by the plan.

What is the significance of the “grant date” for my stock options?

The grant date is the date on which you are awarded stock options. It’s important for determining the holding period, which affects capital gains tax rates, particularly with ISOs.

How does the value of the company’s stock at the time of exercise affect my tax liability?

The fair market value of the company’s stock at the time of exercise is a key factor in determining your tax liability, especially for NSOs, as it directly impacts the amount of ordinary income tax owed.

How does equity compensation compare to cash compensation for tax purposes?

Unlike cash compensation, which is taxed as ordinary income when received, equity compensation’s tax implications vary depending on the type of equity and when it’s exercised or sold.