U.S. venture capital funding is showing temperance but continuing at a rapid pace. In 2016 more than $69.1
billion was invested across 7,751 companies in the entrepreneurial ecosystem, representing the second highest
annual investment total in the past 11 years (second only to 2015’s record tally of $78.9 billion).1 2016
recorded the highest amount of capital raised by venture funds measured in the last ten years – $41.6 billion in
Not surprisingly, many startup companies incorporated and operating outside the U.S. (“Opco”) continue to
seek U.S. venture capital investment, and to this end organize a U.S. company to hold Opco stock and receive
such investment (“US Holdco”). Upon US Holdco’s formation, Opco’s founders/shareholders exchange their
Opco shares for US Holdco shares (often referred to as a “flip transaction”). In view of investor preference,
US Holdco is typically formed as a corporation whose certificate of incorporation will allow for issuance of
convertible preferred stock to VC investors.
Understanding the tax consequences of a flip transaction under both the relevant foreign law and U.S. law is
crucial. The transfer of Opco shares is often taxable under foreign law. From the perspective of U.S. tax law,
the flip transaction generally is not taxable but is consequential because Opco shares are carried into the U.S.
tax jurisdiction. Accordingly, the potential U.S. tax cost of incorporating US Holdco as a taxable corporation
– as well as potential tax benefits for certain U.S. shareholders/investors upon the later disposition of shares of
such corporation – must be considered. To be factored in such consideration is the possibility that under a new
President and Republican-controlled Congress, seismic changes in U.S. tax law may be on the horizon.
While an entire book could be written on all of the considerations that could come into play, below are five
salient points to keep in mind.
1. Corporate US Holdco: Opco Shares Brought into U.S. Tax Jurisdiction. Once the flip transaction
occurs and Opco shares are held by a U.S. corporation, any appreciation in Opco shares and any other
assets of U.S. Opco are squarely within the U.S. tax jurisdiction as follows.
• Sale of Opco shares. Upon the sale of Opco shares by US Holdco formed as a corporation, the
excess (if any) of fair market value of Opco shares at such time over US Holdco’s tax basis in
the shares will be subject to U.S. corporate income tax. The U.S. currently has a maximum
federal corporate income tax rate of 35% (i.e., not considering any applicable state/local tax).
• Liquidation of Corporate US Holdco. The same result generally applies to any liquidation of
US Holdco formed as a corporation, because on U.S. Holdco’s taxable distribution of Opco
shares to its shareholders, US Holdco is treated as selling the Opco shares at their fair market
value.2 A large U.S. tax bill can come as an unpleasant surprise if the founders view US
Holdco simply as a funding vehicle to be dispensed with when U.S. VC funding is no longer
needed.3 Unless Opco has utterly failed to appreciate, founders would be well served to keep
1 See National Venture Capital Association press release, http://nvca.org/pressreleases/peaking-2015-ventureinvestment-
2 Tax-free liquidation treatment, applicable to distributions pursuant to a plan of complete liquidation to an 80%
or greater U.S. corporate shareholder, is unlikely in the startup context.
3 In the event of such a surprise, prompt consideration should be given to whether tax mitigation strategies,
including possibly a “rescission” of the liquidation, may be available.
the corporate US Holdco structure in place until an exit event.
• US Holdco Assets and Possible Reduction in U.S. Federal Corporate Tax Rate. Since any
assets held by corporate US Holdco are within the U.S. tax jurisdiction, it is generally
advantageous from a U.S. tax perspective to hold appreciable tangible and intangible property
outside of the U.S. – e.g., in Opco rather than U.S. Holdco. Of course, overall tax planning in
this regard requires comparison of the applicable U.S. and foreign tax rates.
In addition, implications of the recent U.S. presidential election should be reviewed, as there is
substantial possibility of comprehensive business tax reform including reduction of the U.S.
federal tax rate on corporate income from 35% to 15% (under the Trump plan) or 20% (under
the House Republicans’ plan). Such rate reduction, if it occurs, may favor a structure in which
U.S. Holdco holds not only Opco stock but certain other appreciable property such as IP.
Caution is required, however, as any newly enacted rate may not be permanent under
subsequent administrations and Congress.
2. Exit Scenario – Sale of US Holdco Shares. As may be apparent from the above discussion, corporate
US Holdco selling Opco shares generally would not be a tax-efficient exit strategy. An exit involving
a sale of U.S. Holdco shares would be more sensible from a U.S. tax perspective considering the
• Foreign Persons Generally Not Taxed on Sale of US Holdco Shares. Generally under U.S. tax
rules, gain from the sale of stock of a U.S. corporation by a foreign person is treated as foreign
source income and not subject to U.S. tax (without the need to rely on provisions of an
applicable U.S. tax treaty). An exception applies where stock is of a “U.S. real property
holding corporation,” an unlikely scenario for startups.
• Tax-Efficient Exit: US IPO. If exit occurs by way of an IPO on the U.S. stock market,
corporate U.S. Holdco could serve naturally as the IPO vehicle and any secondary sales in the
IPO by foreign persons would generally be free of U.S. tax under the rule noted above.
• Sale to Strategic Buyer. Alternatively, if exit occurs via a sale of corporate U.S. Holdco
shares to a buyer, U.S. tax could end up being a burden unless the buyer is a U.S. corporation
which can file a consolidated return with U.S. Holdco and avoid a separate layer of U.S.
corporate tax. If, for example, the exit occurs via sale to a foreign buyer, the foreign buyer
may wish to purchase Opco shares (in which case U.S. Holdco would pay tax on any gain) or,
if purchasing U.S. Holdco shares, discount the purchase price due to the potential U.S. tax cost
of Opco shares being held in a U.S. Holdco. Accordingly, the likelihood of this latter exit
scenario will need to be considered in the decision to reorganize into a U.S. Holdco structure.
3. Considerations for Forming US Holdco as LLC. If US Holdco were formed as a limited liability
company and Opco shares are later sold by the US LLC, the US LLC generally (unless it were itself
engaged in a U.S. trade or business or elected to be taxed as a corporation) would not be taxed on any
gain on such sale. In contrast to a corporate US Holdco, only the share of such gain flowing through
to U.S. members (if any) of the LLC would be subject to U.S. tax. However, as noted below this
potential advantage will need to be weighed against the likelihood that U.S. VC investors may prefer
investing in shares of a corporate US Holdco over membership interests in an LLC.
• Flexibility of Tax-Efficient Exit. Due to the absence of LLC-level tax, forming US Holdco as
an LLC preserves the flexibility at exit of either having the LLC sell Opco shares or selling the
LLC interests (including to a foreign buyer) without the potential burden of a corporate level
• VC Preference for Corporate US Holdco. However, VCs may have a predisposition toward
investing in a corporate US Holdco rather than an LLC for tax and non-tax reasons, including
(1) a U.S. corporation is the familiar legal form of a U.S. startup seeking VC funding, and (2)
shares in a U.S. corporation may constitute “qualified small business corporation stock” such
that gain exemption or other benefits for non-corporate investors may be available on
disposition of such stock, as discussed below.
Strategic consideration could be given to forming US Holdco initially as LLC to be
subsequently converted to a corporation as needed. However, potential drawbacks, including
whether such conversion is taxable under Opco’s jurisdiction, must be carefully reviewed.
4. U.S. Tax Obligations and CFC Reporting. US Holdco will have annual tax filing requirements. While
it is not possible to review here all of the federal and state tax filing rules and requirements which may
apply,4 it is worth highlighting US Holdco’s reporting obligation and possibly also taxable income
inclusion in respect of Opco, a controlled foreign corporation (“CFC”).
• Tax and Information Returns. Corporate US Holdco will be required to file an annual
corporate income tax return on IRS Form 1120, even if it earned no income during the year.5
Further, because US Holdco will own greater than 50% of Opco stock, Opco will be a CFC
and US Holdco will be required to include with its annual return an IRS Form 5471 reporting
Opco’s financial information and certain transactions with Opco.6 These tax filing
requirements will increase compliance costs under the US Holdco structure. It should be kept
in mind that penalties apply for failure to timely file Form 5471, including a basic monetary
penalty of $10,000.7
• Possible CFC Income Inclusion. Because Opco will be a CFC, any “subpart F income”
recognized by Opco would be includible as income to US Holdco, a “United States
shareholder,” even without distribution from Opco.8 For most early-stage startups, the
relevant subpart F income is “foreign personal holding company income” (“FPHCI”)
consisting of interest and other types of passive income. A de minimis exception to income
inclusion by United States shareholders generally applies if such FPHCI and certain other
types of subpart F income of the CFC is less than the lesser of (i) 5% of the CFC’s gross
income, or (ii) $1,000,000.9 Thus, for example, if Opco’s interest income accounts for less
than 5% of its total gross income during the year, then US Holdco generally would not include
4 For example, corporations that are 25% or more owned by a foreign shareholder are generally required to file
Form 5472 if there is a “reportable transaction” between the corporation and such shareholder or related party.
However, if all of such reportable transactions are reported on Form 5471, then a Form 5472 is not required to
be filed with respect to such shareholder.
5 If formed as US LLC and assuming it has more than one member, US Holdco generally will be required to file
a partnership return on IRS Form 1065.
6 Form 5471 filing requirements, and subpart F income inclusion rules discussed below, would apply even if US
Holdco were formed as US LLC because a US LLC would be a “US person” with respect to which Opco is a
CFC for U.S. federal income tax purposes.
7 It may be possible to obtain a waiver of the penalty but this waiver is limited to certain narrow circumstances.
8 Under a “high tax” exclusion, subpart F income treatment does not apply if Opco is subject to an effective tax
rate that is not less than 90% of the maximum U.S. corporate income tax rate.
9 On the flip side, if the CFC’s gross income is made up of more than 70 percent of the sum of FPHCI and certain
other types of subpart F income, the CFC’s gross income for the entire year will be treated as if it were subpart
such interest income on its tax return.
Legislative changes mulled by President-elect Trump and the Congress will also need to be
reviewed. It is possible that the subpart F income and other rules designed to limit U.S.
corporations’ deferral of foreign earnings may be modified or eliminated under anticipated
U.S. tax reform legislation.
5. Special Considerations for Founder-Shareholders Who Are (or may become) U.S. Citizens or
Residents. While foreign shareholders generally are not subject to U.S. tax on the disposition (or
receipt) of US Holdco shares, Opco shareholders who are U.S. citizens or residents will have a
particular interest in reviewing the U.S. tax rules applicable to their situation.
• Section 83 and Receipt of Restricted Stock. If, in the flip transaction, US Holdco issues nonvested
shares to former Opco shareholders that subsequently vest based on conditions tied to
the performance of services (which may be agreed in connection with defining the respective
contributions and roles of co-founders), the shareholders will need to consider the application
of section 83 of the U.S. Internal Revenue Code (“Code”). Generally under section 83(a),
where property (such as stock) is transferred in connection with the performance of services,
an amount equal to the fair market value of the property less any amount paid by the recipient
for such property is includible in the recipient’s income at the first time the property is not
subject to a substantial risk of forfeiture (or is transferable).
Because the above rule can lead to ordinary income inclusion at a later (i.e., vesting) date
when shares have a much higher fair market value, section 83(b) allows the recipient to elect
to recognize income currently equal to the property’s fair market value on the date of grant of
the restricted stock (less any amount paid for the property). Such election must be made by
filing an election statement with the IRS within 30 days of the grant date.
In a flip transaction where there is a value-for-value exchange of Opco shares for U.S. Holdco
shares, filing a section 83(b) election should not result in income inclusion (as there was full
payment for the shares), but would permit any gain on disposition of such shares to be treated
as capital gain. Accordingly, any former Opco shareholders who receive non-vested US
Holdco shares and who are or expect to become U.S. taxpayers should strongly (and
promptly) consider filing a section 83(b) election.
• Beneficial Provisions for Small Business Corporation Stock. Following recent legislative
changes to Code Section 1202, an individual shareholder who acquires “qualified small
business stock” (“QSBS”) of a U.S. corporation and holds the QSBS for more than five years
is eligible to exclude from income potentially the entire amount of gain realized on disposition
of the QSBS, subject to certain limits. Generally, the stock must have been originally issued
to the shareholder and the relevant corporation must constitute a “qualified small business,”
which requires in salient part that through the time immediately after issuance of the stock, the
corporation’s gross assets not have exceeded $50 million and that at least 80% of its assets be
used in a qualifying active business (which excludes certain categories such as professional
services, banking/insurance and finance businesses, farming, mining and hospitality).
Helpfully for a US Holdco which may not itself engage in an active business, a look-through
rule applies pursuant to which a parent corporation generally is deemed to own a subsidiary’s
assets and operate its business.
Generally, the amount of excludible gain is limited to the greater of (i) $10 million or (ii) 10
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times the taxpayer’s basis in the QSBS which was disposed during the year.10 This
benefit may apply also to individuals who are indirect shareholders such as investors in a fund
organized as a partnership. Accordingly, VC investors may require in their stock purchase
agreements representations from US Holdco regarding qualification as a small business
U.S. tax laws and strategies to navigate the laws are complex. If nothing else, the takeaway for Opcos and
their founders should be to become a U.S.-parented company (or otherwise enter the U.S. jurisdiction) only
after obtaining strategic U.S. tax advice. And that advice must deal with possible legislative changes which
are on the horizon following the recent U.S. presidential election.
Hoon Lee Law PLLC assists domestic and cross-border enterprises and investors with strategic
counsel in planning and implementing their ventures and transactions. The firm leverages 15+
years’ U.S. and international tax experience structuring transactions for companies, funds and
individuals and achieving optimal results. We invite you to contact us to explore transaction
structuring and tax planning strategies.
10 If stock qualifies as QSBS and is held for more than six months but not more than five years, rollover of capital
gain realized upon a sale may be available under Code Section 1045 to the extent the taxpayer purchases other
QSBS within 60 days after the sale. This may be attractive for serial venture investors and entrepreneurs. Under
a separate provision (Code Section 1244), loss on certain small business corporation stock of up to a limited
amount is afforded ordinary loss treatment rather than capital loss which may have less utility.