How to Shelter Gains from Stock Warrants

warrants to bridge the gap to close capital raise investments. In most cases, stock warrants are granted for either zero value or below market value as part of the investment into the business. Unlike stock options which can be bought on the open market, stock warrants are not traded there and are sold directly by the issuing company. This article will cover the tax benefits of using a Self-Directed Roth IRA to buy private business warrants and shelter all gains.

What are Financial Instruments

Financial instruments are contracts or agreements that have monetary value and can be traded on financial markets. They serve various purposes such as raising capital, managing risk or speculating on price movements. They can range from simple agreements like stocks and bonds to more complex derivatives like options and warrants.

Each financial instrument has its own characteristics that make it suitable for different investment strategies and financial goals. Understanding these characteristics is key to making informed investment decisions and managing financial risk.

What are Stock Warrants?

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

There are two types of stock warrants: call warrants and put warrants. A call warrant gives the holder the right to buy shares at a specified price in the future. A put warrant gives the holder the right to sell a specific stock or asset to the issuer at a set price before a certain date.

In an era of higher interest rates, many start-ups and growth companies looking to raise capital have turned to stock warrants as a sweetener to incentivize investors to invest. Some companies will also use warrants when structuring strategic partnerships or investments to incentivize the other party. Stock warrants are contracts between two parties, typically the issuing company and the investor.

Warrant Characteristics

A stock warrant is a financial instrument that gives the holder the right but not the obligation to buy or sell a company’s stock at a specified price called the strike price on or before a specific date called the expiration date. Companies issue stock warrants to raise capital or as part of an employee compensation package. These warrants can be traded on the secondary market and their value is influenced by the underlying company’s stock price and time to expiration. The flexibility and potential for big gains make stock warrants an attractive option for investors looking to ride a company’s growth.

Options vs Warrants

The differences between options and warrants often cause confusion especially when it comes to company options. Warrants are similar to options in that they serve the same purpose 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. Company options are typically issued under a formal option plan. Stock options are used in an employee compensation context and stock warrants are used in transactions with third parties.

There are two types of warrants: call warrants which allow the holder to buy shares at a specific future price and put warrants which allow the holder to sell shares at a predetermined price.

Tax Treatment of Stock Warrants

Exercising a warrant is 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 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 and the costs involved in exercising stock warrants can impact investment decisions.

Stock options can be eligible for preferential tax treatment unlike stock warrants. Most warrants can be exercised in whole or in part by paying the cash exercise price. Some warrants also allow for a “cashless exercise.” A cashless exercise allows the warrant holder to exercise the warrants upon a capital event without 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.

Types of Instruments

Investors have access to various instruments, each with its own characteristics, risks and rewards. Common ones are stocks, bonds, options, and warrants. Stocks represent ownership in a company and entitle the holder to a portion of the company’s profits. Bonds are debt instruments that pay interest over time. Options give the holder the right to buy or sell an asset at a predetermined price.

Stock warrants, on the other hand, provide the opportunity to participate in a company’s growth and potentially earn big gains. But they come with high risk as the value of the warrant can expire worthless if the underlying stock price does not move in the desired direction.

Issuance and Exercise

When a company issues stock warrants, it gives the holder the right to buy a certain amount of stock at a specified price. The holder can exercise the warrant at any time before the expiration date obligating the company to issue new shares. The exercise price is typically set at a premium to the current market price providing an incentive for the holder to invest.

The issuance and exercise of stock warrants can significantly impact the underlying company including the potential dilution of existing shareholders’ stakes. This allows companies to raise capital while offering investors a chance to benefit from future stock price increases.

Owning a Warrant in an IRA

When it comes to making investments with an IRA, the IRS doesn’t 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 account owner or a disqualified person, one can use his or her retirement account to make the investment.

Investing in stock warrants through a Self-Directed IRA can provide significant tax advantages.Unfortunately you cannot invest in a non-publicly traded investment using an IRA at a traditional financial institution such as Schwab or Fidelity; you need to “self-direct” your IRA with a special custodian, such as IRA Financial, to make stock warrant investments.

The mechanics of payment involved in using retirement funds to purchase stock warrants typically include setting up a payment plan with the IRA custodian and ensuring all financial transactions comply with IRS regulations.

What is a Self-Directed Roth IRA?

A Self-Directed Roth IRA is a type of retirement account that allows your money to grow tax free. You contribute to it with after-tax dollars, meaning you’ve already paid taxes on the money you put in. In return, your investments grow without tax. Qualified withdrawals in retirement are also tax free.

Key Features of a Roth IRA:

• Tax-free growth: You don’t pay taxes on investment earnings.
• Tax-free withdrawals: If you’re age 59 ½ or older and the account has been open for at least five years, you can withdraw both contributions and earnings without paying taxes.
• Contribution limits (for 2025): Up to $7,000 per year (or $8,000 if you’re age 50 or older).
• No required minimum distributions (RMDs) during your lifetime.
• Flexible access: You can withdraw your contributions at any time without penalty.

A Roth IRA is especially beneficial if you expect to be in a higher tax bracket in retirement or want tax-free income later in life. Just like a traditional plan, you can make alternative assets, including stock warrants with a Self-Directed Roth IRA.

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. If you 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 then the gain would be subject to short-term capital gains rates which equal ordinary income tax rates. Conversely, if the stock is held greater than twelve months then a reduced capital gains rate would apply.

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. Stock warrants also allow companies to issue new stock which can be beneficial for raising capital.

The reason a Roth IRA works so well in the context of stock warrants is that at grant the warrant has very low value (oftentimes zero) so, almost anyone can 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 many 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.

Issuing stock warrants can also address various business issues by impacting a company’s financial standing, generating revenue from both the initial sale and potential exercise of the warrants. Stock warrants typically have longer expiration dates compared to stock options, often ranging from five to 15 years. Stock warrants can be attached to bonds to attract investors.

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 stock 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.

Time Value Considerations

The value of a stock warrant is greatly affected by time to expiration and underlying stock price. The longer the time to expiration, the higher the potential value of the warrant as it gives more time for the stock price to move in your favor.

Further, the value of the warrant is affected by the volatility of the underlying stock price, interest rates and other market factors. Investors should consider these time value factors when buying or selling stock warrants as they can have a big impact on returns.

Conclusion

Stock warrants are a great way for private businesses to incentivize investors and sweeten the investment transaction. 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 an option for many investors looking to shelter the gains from the future sale of the business. Investors interested in stock warrants should understand their tax benefits and potential returns.

Any questions? Feel free to contact us at 800.472.1043 to speak with one of our account specialists.