Why VCs need a great tax accountant
Welcome to the third edition of "Back Office Ops for VCs"... a journey that has taken us through the wild world of fund admin and fund audits.
Today we dive into the next back-office vendor that can make or break a fund: tax accountant.
- 3 examples of complicated and common tax situations for VCs
- what to look for in your tax accountant
- how to find a great tax accountant
And if you're too busy to read the whole thing, scroll for the TL;DR.
First, a disclaimer
Look. I know this stuff can be tedious. But stay with me, cuz there are lots of learnings in here.
Why you need a good tax person
Taxes for VC funds can be super complicated. Because there is so much money moving in and out of the fund, you need someone who can look at these complicated situations, dumb things down for you, give you a bunch of options, and help you make a decision on how to proceed.
Here are three examples of complicated tax stuff that you'll probably run into if you launch a fund:
Example 1: You recycle returns back into the fund
This is pretty common, especially in the earliest years of a fund's lifespan.
Let's say you invest into a portfolio company that has a small exit. Your return is $50k. That amount is spread out across all your LPs, so each LP will only receive about $1k. It's such a small amount to return to your investors, so you may decide instead to put the money back into the fund. You could invest into a new startup or write a follow-on check into an existing company.
This is totally acceptable. However. You are still obligated to report this return to your LPs, and your LPs will have to pay taxes on the return... even if they don't see a dime in their bank accounts.
This is where a tax accountant comes in. It's her job to help you weigh your options and pick a path that feels right.
Should you return the entire amount to your LPs? Should you return no money to your LPs? Should you return just enough to cover your LPs' taxes on that return? If you go that route, how to calculate the amount for each person?
These are questions you'll want your tax accountant to weigh in on.
Example 2: A portfolio company gets acquired for stock
Let's say one of your portfolio companies gets acquired in an all-stock acquisition. This means that instead of a cash return, your fund receives a bunch of stock in the acquiring company.
You still have to report this to your LPs and to the government. But how to calculate the value of the stock? What happens if it's part-cash, part-stock acquisition? How to calculate THAT value? What do we do with the stock? Do we sell it on behalf of our LPs and then return cash to our investors? Or do we allocate shares to our LPs and let them decide what to do with it?
It's messy... and a reasonably likely scenario for early-stage VCs. So you'll want a good tax accountant to help you sort through it all.
Example 3: You write a follow-on check years later
Let's say you invested into a startup 6 years ago. Then, 3 years later, you invested into that same company again.
Well, there's a QSBS rule that may allow you to get a big tax break for any investment that was made more than 5 years ago. When this company gets to exit and you get a return, what does that mean for your taxes?
Do you get a tax break on the whole amount even though part of your investment was made fewer than 5 years ago? Does the more recent investment re-set the clock on the QSBS rule? Does only part of your return qualify for the tax break?
Again, this is where you want a super savvy tax accountant to help you navigate these waters.
What makes a great tax accountant?
Ideally you're looking for a tax accountant that checks these 5 boxes:
1) super responsive
3) good at dumbing things down
4) good at explaining the range of how to interpret risk
Numbers 1 and 2 are self explanatory. Let's dig in a bit to numbers 3-5.
Good at dumbing things down
Most VCs are not tax experts. And frankly, the language around tax law is confusing and arcane. A great tax accountant will distill down the situation into easily-understandable terms so you can quickly and confidently make decisions.
Good at explaining range of how to interpret risk
Fun fact: tax laws are open to interpretation! You can interpret the laws conservatively... or less so. A great tax accountant will give you options across a broad range of interpretations.
In a given situation, a great tax accountant might say:
"Here's the most conservative option you can take. It's federal audit-proof. But the risk that we're guarding against almost never happens. So here's a less conservative option that's still legal and may be more beneficial for you and your LPs."
Since tax laws vary from state to state, AND tax laws are constantly changing, you want an accountant who is proactive. Someone who is looking out for your business even when they don't have to.
For example, your tax person might call you one day and say "Hey I noticed that this tax law in California just changed. If we do x, y, and z things, we can save 3% on your taxes this year. Do you wanna do this?"
This is the mark of a great tax accountant.
How to find this person?
Much like other back-office vendors, the best way to find a great tax accountant is through referrals from people you trust.
Be prepared to shell out some big bucks for a great tax accountant – the right person will likely save you boatloads of money in the long run.
Can I get a TL;DR?
Yep. Taxes for VCs are super complicated. And the risk of mismanaging your taxes – or misreporting your returns – is high. A federal audit that unearths bad practices will kill your fund and could lead to major fines (or even jail time).
It's well worth it to find an excellent tax accountant to ensure your fund is compliant and making smart decisions for you and for your LPs.
Great tax accountants are also expensive. So... stop buying avocado toast, I guess?