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How to Shelter Gains from Stock Warrants

Stock Warrants

Over the last few years, especially in 2023 and 2024, there has been a growing trend in the number of start-up and growth private businesses using stock warrants to help bridge the gap to close capital raise investments. In most cases, stock warrants are granted for either a value of zero or a below market value as part of the enticement to make the investment into the business. This article will explore the tax advantages of using a Self-Directed Roth IRA to acquire private business warrants and gaining the ability to shelter all gains from tax.

What is a Stock Warrant?

In general, a stock warrant is an agreement between a company and the investor or warrant holder. The warrants would entitle the warrant holder to acquire shares or interests in the company at a specified price with a set period of time. In most cases, warrants do not normally permit the warrant holder to company dividends, profit allocations, or voting rights. Warrants are very valuable exclusively for their potential to generate value from the sale of the business assets or interests.

In an era of higher interest rates, many start-ups and growth companies seeking to raise capital have increasingly turned to stock warrants as a sweetener to incentivize investors to invest. Additionally, some companies will occasionally use warrants when structuring strategic partnerships or investments to incentivize the other party.

Options Versus Warrants

Warrants often get confused with the issuance of company options. Warrants are similar to options in terms of serving the same intended function of capturing growth in a business. The main difference is that options are generally offered to company insiders or employees, and warrants are granted to third-party investors or board members. Furthermore, company options are typically issued under a formal option plan.

Tax Treatment of Stock Warrants

The exercise of a warrant results in a taxable event at the time the warrant is exercised. The taxable portion of the warrant is the difference between the exercise price and the current price of the underlying company stock. For example, if a stock is trading at $10 per share and you have a warrant that allows you to buy the shares at $5 per share, the $5 difference would be taxable. However, the tax due would be ordinary income tax. In the future, when the stock you now own is sold, the sale would be governed by the capital gains regime.

Most warrants are exercisable in whole or in part by paying the cash exercise price. However, some warrants also allow for a “cashless exercise.” A cashless exercise allows the warrant holder to exercise the warrants upon a capital event without actually paying for the warrants. An issue with a cashless exercise upon a capital event is that the tax treatment of the warrants would likely be subject to ordinary income tax or short term-capital gains tax

Owning a Warrant in an IRA

When it comes to making investments with an IRA, the IRS generally does not tell you what you can invest in, only what you cannot invest in.  The types of investments that are not permitted to be made using retirement funds is outlined in the Internal Revenue Code. These rules are generally known as the “Prohibited Transaction” rules. Other than life insurance, collectibles, and transactions that involve or directly or indirectly benefit the IRA owner or a disqualified person, one can use his or her IRA to make the investments.

Unfortunately, one cannot invest in a non-publicly traded investment using an IRA at a traditional financial institution, such as Schwab or Fidelity. Hence, one needs to use a Self-Directed IRA company, such as IRA Financial, to make alternative investments including stock warrants.

What is a Self-Directed Roth IRA?

A Self-Directed IRA is essentially an IRA that allows for alternative asset investments that are non-publicly traded. Traditional financial institutions do not allow IRAs to invest in IRS approved alternative assets, such as real estate, because their focus is on earning fees through traditional investments. Hence, the birth of the Self-Directed IRA industry. 

The Relief Act of 1997 introduced the Roth IRA, which is an after-tax IRA which allows any US person with earned income under a set income threshold to make after-tax contributions. For 2024, you can contribute up to $7,000, plus an additional $1,000 if you are at least age 50. So long as any Roth IRA has been opened at least five years and the Roth IRA owner is over the age of 59 1/2, all Roth IRA distributions would be tax free.

Tax Advantage of Owning Stock Warrants in a Roth IRA

The primary tax advantage of using a Roth IRA to acquire a stock warrant is that all gains from the exercise and sale of the warrant would be tax free. In contrast, if one exercised a warrant in a private business that was in the money, the exercise and later sale of the stock would trigger ordinary income tax and a capital gains tax in the sale of the stock. If the stock was held less than twelve months than the gain would be subject to short-term capital gains rates, which equal ordinary income tax rates, and if the stock is held greater than twelve months then a reduced capital gains rate would apply. However, if the warrants were acquired by a retirement account, a tax-exempt savings vehicle, there will be no tax until you withdraw from the plan.

The reason the use of a Roth IRA works so well in the context of the grant of stock warrants is that at grant, typically the warrant has very low value (oftentimes, zero) allowing almost anyone with a Roth IRA to acquire the warrant. From an IRS perspective, the two keys to keep in mind when acquiring a warrant is to make sure the IRA is paying fair market value for the warrants (even if it is zero), and that the IRA owner and their family members will own less than 50% of the company at grant.

How to Structure Stock Warrants

There are a number of ways to structure stock warrants, however, one way that can help a non-retirement account benefit from capital gains treatment is to structure the warrants in a way that they mirror a class of units or LLC interests. Essentially, the concept is that instead of requiring the investor to have to exercise the warrant and likely have to deal with ordinary income and short-term capital gain treatment on a capital event, the idea is to create a class of units that essentially only get paid out on a capital event based on a distribution waterfall in the company operating agreement. Because of this, the warrants are basically turned into class interests that mirror the economics of warrants for a capital event, but only would participate in the economics of the business on a sale.

On the other hand, the use of a Roth IRA to acquire the warrants will ensure tax-free treatment on the sale of the underlying stock or company interests. Additionally, the use of an IRA to purchase warrants works best when the investor is not an employee of the business. This is because the use of a Self-Directed IRA by an employee in connection with a grant of warrants could look more akin to employee incentive options which could be problematic from an IRS perspective. 

Conclusion

The use of stock warrants is a great way for private businesses to incentivize investors and sweeten the investment transaction opportunity. Warrants allow investors to share in the upside of the business and benefit on the sale of the business. Because most warrants are granted for free or at a low value, the use of a Self-Directed Roth IRA is a viable option for many investors seeking to shelter the gains from the future sale of the business.

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