TL;DR (Too Long; Didn't Read)
The Tax Trap: If a secondary sale is structured as a direct company buyback or lacks a "compensatory link" defense, the IRS may recharacterize your long-term capital gains as "Ordinary Income," jumping your tax rate from 20% to as high as 37%.
The Structure Matters: Selling via a third-party tender offer is generally safer than a direct company redemption. Proper documentation must prove the sale price represents "Fair Market Value" (FMV) rather than a hidden bonus.
The Solution: Founders must ensure the transaction is handled through an independent secondary market or a properly structured "Waterfall" to preserve Capital Gains treatment.
The Symptoms: When Opportunity Feels Like a Penalty
You’ve spent seven years building a high-growth startup. You’re "paper rich," but your bank account doesn't reflect your Series D valuation. An outside investor wants more ownership and offers to buy $2 million of your vested common stock.
You do the math: “I’ve held this for years. 20% Long-Term Capital Gains (LTCG) plus the 3.8% Net Investment Income Tax. I’ll clear roughly $1.5 million.”
Then you talk to a conservative CPA or a sophisticated tax attorney, and they drop the hammer: "If we don't structure this correctly, the IRS will view this $2 million as a performance bonus."
Suddenly, that 20% rate skyrockets to a 37% federal top marginal rate, plus payroll taxes (FICA/FUTA), and state taxes. You aren't losing 23.8%—you’re losing nearly 50% of your liquidity to the government. This is the reality of the "Secondary Sale Recharacterization" trap.
The Technical Deep Dive: Why the IRS Wants Your "Capital Gains"
At its core, the IRS is suspicious of any money moving from a company (or an investor) into a founder’s pocket. They want to know: Is this a sale of property, or is this payment for services rendered?
1. The "Compensatory" Argument (Section 83)
Under IRS Section 83, if you receive property (or cash) in connection with the performance of services, it is treated as ordinary income. In a secondary sale, the IRS often argues that if an investor pays a premium over the current 409A valuation to buy your shares, that premium isn't a capital gain—it’s a "disguised bonus" intended to keep you motivated at the company.
2. The 409A Valuation Gap
This is where most founders get tripped up.
409A Value: The "Fair Market Value" for tax purposes (usually conservative).
Preferred Price: What investors pay for preferred stock (usually much higher).
Secondary Price: Often somewhere in the middle.
If you sell your common shares at $10.00/share, but the most recent 409A valuation says common stock is worth $4.00/share, the IRS sees a $6.00 difference. Without the right legal "armor," they will claim that $6.00 is ordinary income, subject to immediate withholding.
3. Redemption vs. Tender Offer
Redemption (The Danger Zone): The company buys the shares back from you using its own cash. This is frequently classified as a "dividend" or "compensation" unless it meets very strict "substantial reduction in interest" tests under Section 302.
Third-Party Tender Offer (The Safer Route): An outside investor buys your shares directly. Because the company’s balance sheet isn't involved, it looks more like a standard "arm's length" transaction. However, even here, if the company facilitates the deal too heavily, the IRS can still argue it's compensatory.
The Expensive Mistake: Doing a "Handshake" Deal
The most expensive mistake a founder can make is treating a secondary sale like a private Venmo transaction.
The Scenario: You agree to sell $1M worth of stock to a friendly VC. You sign a simple Stock Purchase Agreement (SPA). You report it as capital gains on your Form 1040.
The Fallout: Two years later, the IRS audits the company. They notice the transaction and rule that because the price was above the 409A value, the company failed to withhold payroll taxes.
For the Company: They are hit with massive penalties for unpaid employer-side taxes.
For You: The IRS reclassifies your $1M. You now owe the difference between 20% and 37%, plus interest, plus an accuracy-related penalty (usually 20% of the underpayment).
In this scenario, a $1,000,000 exit that should have netted you $762,000 ends up netting you closer to $450,000 after the IRS is done. You’ve effectively set $300,000 on fire because of a structural technicality.
How to Protect Your Exit: The "Rally" Approach
To ensure your secondary sale qualifies for Capital Gains, you need to establish three things:
No Company Cash: Ensure the liquidity is coming from an outside source.
The "Arm's Length" Defense: You must prove that the price paid by the investor is what any rational person would pay in an open market, regardless of your employment status.
QSBS Eligibility: If your company is a C-Corp and you’ve held your shares for over 5 years, you might qualify for Section 1202 (QSBS), which could make your gain 0% taxable. But if the sale is recharacterized as "Ordinary Income," you lose the QSBS benefit entirely.
The "Waterfall" Strategy
Smart founders use "Waterfall" analysis to model out exactly how much they will keep after taxes before signing the secondary agreement. This involves:
Comparing the 409A to the Secondary Price.
Assessing the "Compensatory" risk based on recent IRS rulings.
Structuring the sale through a dedicated secondary platform or a specialized "Series" vehicle to distance the transaction from the company's payroll.
The Rally Solution: Stop Guessing, Start Planning
You spent years building your equity; don’t let a structural error hand half of it to the IRS. Rally provides a streamlined, tech-forward way to protect your exit without the immediate overhead of traditional firm retainers.
We’ve simplified the process of navigating IRS Section 83 and 302 into two clear steps:
Get Your Free AI Tax Plan: Simply upload your documents to Rally. Our platform analyzes your equity data to generate a comprehensive, AI-powered tax plan—tailored to your secondary sale—at no cost to you.
Consult with a CPA: Once you’ve reviewed your plan, you can schedule a call with a specialized CPA directly through the platform to discuss the results, refine your strategy, and ensure your "Net-of-Tax" number is protected.
Secure Your Secondary Sale
Ready to take some chips off the table? Don’t sign that SPA until you know your actual take-home pay.
Rally Tax is an Authorized IRS e-file Provider and SOC2 Compliant.
Frequently Asked Questions:
1. What is the "20% Rule" in secondary sales?
The IRS often looks for a "safe harbor" when founders sell shares. If the price of the secondary sale is significantly higher than the most recent 409A valuation, the risk of recharacterization increases. Tax professionals often analyze whether the secondary price is within a reasonable range of the "Fair Market Value" to argue against it being treated as a compensatory bonus.
2. Does a secondary sale trigger a new 409A valuation?
It can. If a significant amount of equity changes hands, the board may determine that the sale constitutes a "material event." This could force the company to increase its 409A valuation, which makes future stock options more expensive for new employees. This is why many companies prefer third-party tender offers over direct buybacks—to keep the secondary price from directly dictating the common stock's tax value.
3. Can I use QSBS (Section 1202) on a secondary sale?
Yes, provided you meet the requirements: the company must be a domestic C-Corp with less than $50M in gross assets at the time of issuance, and you must have held the shares for at least five years. If you qualify, you could potentially exclude 100% of the capital gains from federal tax. However, if the sale is recharacterized as "Ordinary Income," you cannot apply the QSBS exclusion to those funds.
4. What is the difference between a "Tender Offer" and a "Secondary Market" sale?
Tender Offer: A structured event, often company-sponsored, where an investor offers to buy a specific number of shares from a group of employees/founders at a set price.
Secondary Market: An ongoing marketplace (like Forge or Nasdaq Private Market) where individual buyers and sellers trade shares. From a tax perspective, a third-party tender offer is generally easier to defend as a capital transaction than a company buyback.
5. Will I have to pay the Alternative Minimum Tax (AMT) on a secondary sale?
Typically, no. AMT is usually triggered when you exercise ISOs (Internal Stock Options) and hold them. Since a secondary sale is a "disposition" of shares where you receive cash, you are simply paying capital gains tax. However, if you exercise and sell in the same year (a "cashless exercise"), the spread is taxed as ordinary income, not capital gains.
