Many non-US startup founders initially incorporate in their home country and then decide to reincorporate or create a subsidiary in the US. There are many advantages for foreign founders to move operations to the US, including venture capital (VC) financing and customer base expansion. However, many tax considerations exist for founders contemplating a move to the US. Among them, qualified small business stock (QSBS) can provide significant tax benefits for foreign founders who become US taxpayers. But foreign founders must plan carefully for QSBS benefits as they move company operations to the US if they are going to be subject to US tax at the time of exit.

QSBS Benefits

In general, founders based in the US who sell shares of their startup companies to a strategic or private equity buyer or after IPO will pay US federal income tax at long term capital gains rates of 23.8%, plus state income tax in certain cases. A founder who lives in California and sells startup shares with little to no basis for $10,000,000 will generally pay federal income tax of about $2,380,000 and California state tax of about $1,330,000.

However, if a founder's shares are QSBS under Internal Revenue Code (IRC) section 1202, that founder can avoid all federal income tax on up to $10,000,000 of gain. Assume the same founder sells shares in the startup for $10,000,000 and the shares constitute QSBS. In such case, the founder will be subject to no federal income tax on the sale of the company (and potentially no state income tax for residents of states that conform to the QSBS rules).

In order to enjoy QSBS tax benefits, a founder must generally receive shares of a US C corporation at “original issuance” – meaning in exchange for cash, property (other than shares of another corporation), or services at the time the corporation has less than $50 million of aggregate gross assets. The founder must hold the shares for over five years and, for substantially all the holding period, 80% of the assets of the corporation must be used in a qualified trade or business. While a full discussion of QSBS rules is beyond the scope of this guidance, startups primarily engaged in developing technology, rather than professional services, generally represent a qualified trade or business for section 1202 purposes. Typically US founders, early employees, and VCs in early funding rounds will qualify for QSBS tax benefits on the sale of their startup shares.

Planning Issues for Moving Foreign Startups to the US

For foreign founders planning to move their businesses to the US and become US taxpayers, QSBS can provide significant future tax benefits. To take advantage, foreign founders need to plan carefully to ensure that they satisfy the general requirements to obtain QSBS benefits.

Delaware Flip

A common technique for foreign corporations to move operations into the US is through a “F reorganization” under IRC section 368(a)(1)(F), commonly known as a Delaware flip. In such transactions, the shareholders will exchange shares of the foreign company for shares of a domestic (normally Delaware) corporation. The flip provides an efficient vehicle to reorganize a foreign corporation in the US.

The flip structure will almost never allow a foreign founder to obtain QSBS for the shares issued in the reorganization. The flip is predicated on all the existing owners, including the foreign founder, exchanging foreign shares for shares of a US corporation. This exchange fails to satisfy the “original issuance” requirement for QSBS because the founder does not receive the shares of the US corporation in exchange for cash, property, or services, but rather in exchange for shares of a foreign corporation.

US Subsidiary

An alternative structure may allow foreign founders to obtain QSBS benefits but involves different potential risks. If the foreign corporation creates a US subsidiary that directly issues shares to the foreign founder, that founder may be able to obtain QSBS at the time the US corporation is sold. In these cases, the foreign founder may receive shares of the US corporation through equity incentives or otherwise. Unlike the Delaware flip, the US subsidiary structure satisfies the original issuance test.

However, the US subsidiary structure introduces potential tax and logistical issues. First, if the US subsidiary is immediately valuable at the time of formation, then the founder may have a large tax burden when acquiring shares in connection to services. Second, the foreign founder will only obtain QSBS benefits when selling shares of the US corporation. Provided the foreign parent is sold, the foreign founder may still be subject to US tax. Finally, businesses often reorganize into the US in order to obtain financing from VCs. VCs may prefer to house the corporation’s intellectual property (IP) in the US subsidiary. If valuable pre-existing IP remains in the foreign parent, developed with previous funding, the US VCs may be less willing to invest.

Brother-Sister Structure

Another option for founders to secure QSBS benefits is to establish a brother-sister relationship between the foreign corporation and the US corporation. In such a structure, the US corporation is held separate from the foreign corporation, and the two entities are connected through a license or similar agreement on the existing IP but mutually controlled. To avoid abuse, transfer pricing rules apply to inter-company transactions. In this case, early shareholders may be able satisfy the original issuance requirement at a lower value on the shares. As with the parent-subsidiary model, the structure may present challenges when US investors prefer IP to sit in the US corporation, not the foreign corporation.

Advanced Structuring

Generally, an ending structure with a US parent and foreign subsidiary is the desired outcome for US-based investors, rather than a foreign parent-US subsidiary or brother-sister structure. Depending on the timing, nature of the business and its assets, it may be possible to achieve this final structure through multi-step planning. In these cases, companies may be able to achieve their desired business objectives while also allowing for potential QSBS issuance to their founders.

Conclusion

There are no simple solutions for foreign companies to reorganize their operations in the US with the issuance of QSBS to their founders or early investors. If companies and their counsel are aware of the potential issues and plan for tax benefits to their early-stage owners (while not compromising business goals), then it may be possible to allow for QSBS issuances.