If you take a few legal precautions at the outset, you and your employees can sidestep some painful tax consequences
Working with outside investors to finance an early-stage company by issuing stock can be stressful, time-consuming, and complex. For the most part, founders will focus on just a few key areas such as valuation and liquidation preferences. Most will overlook tax-planning, placing a big chunk of potential earnings for themselves and their employees at risk. To avoid this, founders should seek the assistance of a tax expert, such as a CPA or a tax attorney who understands the nuances of early-stage companies. To get a sense of two common tax pitfalls and ways to avoid them, consider the following:
Pitfall: Getting hit with a large tax bill when selling your company's stock.
Suggestion: Make a so-called Section 83(b) election.
Let's say your company, XYZ Corp., is raising $2 million from investors by issuing preferred stock. As the founder, you get 100,000 shares of common stock valued at 10¢ per share from your investors through a common arrangement known as reverse vesting. These shares vest over a four-year period. After year one, you receive ownership of 25% of the 100,000 shares. However, the value of the shares is now $1. Good, huh? Maybe not. You see, you now owe personal income taxes on the $22,500 gain. What's more, your company will need to pay federal payroll taxes on this amount.
However, if you had made a so-called Section 83(b) election with the IRS when the shares were issued to you, you could have avoided this problem. The reason is that the stock price will likely have been the same as the fair market value at the time that you received the shares, so there would be no gain on the transaction. Bear in mind, you need to send in the 83(b) election form within 30 days of receiving the shares. What is the main risk involved in doing this? You will pay the original share price to your company because you will have to purchase new shares in common stock in order to avoid a tax liability. However, if your company fails, you will lose your money.
Pitfall: Employees owing a lot of taxes on stock options.
Suggestion: Prepare a so-called Section 409(A) deferred compensation report.
Imagine your company, ABC Corp., issues a option to an employee to purchase 100,000 shares at 10¢ each (this price is called the "exercise price"). Then, within a year, the company sells 1 million shares at $1 per share. The problem for employees comes when they prepare tax returns. The IRS may challenge the exercise price of the option as being below the fair market value. Consequently, an employee may be subject to ordinary income taxes on the difference between the exercise price and the fair market value as the option vests.
Moreover, under recent IRS rulings, the employee will be subject to an additional 20% in federal tax, and in some cases even additional state tax. The employee will owe these taxes even if the employee cannot sell the shares. In other words, you are likely to have some disgruntled employees, which could be a serious drag on your company.
The IRS does have a solution for this problem. Basically, ABC Corp. must show that it is issuing options that have exercise prices that are equal to the fair market value of the underlying shares. "To do this," says Yoichiro Taku, who is a deal attorney at Wilson Sonsini Goodrich & Rosati and the operator of the Startup Company Lawyer blog, "a firm needs to get a valuation report that meets the requirements of the IRS." Taku says that it can cost between $5,000 to $20,000 for a valuation report. While this may sound high, it's worth it in terms of creating employee goodwill because your employees will be saving money on potential tax obligations.
Of course, there are complex rules regarding who can prepare such reports. Essentially, it can be a third-party firm or even an individual within the company, so long as the person has a financial background that meets IRS requirements.
As you can see, there are serious tax implications for founders to consider when issuing stock. Making a few key decisions with tax time in mind can save you and your employees a bundle.