Question: What are the most tax effective ways for founders to “Pay themselves” for efforts in a startup after the initial startup share allocation round. Is there a more effective method apart from options?
Answer: Well, option grants are a tried and true method of post-funding Founder compensation, but not all options are created equal. Option grants to Founder employees working for a funded corporation should be made under the terms of a stockholder- approved employee incentive plan (“Plan”) that permits the issuance of incentive stock options (“ISOs”). With ISOs, the tax on any increased value of the underlying shares between the dates of option grant and option exercise is deferred until the underlying shares are sold—not on option exercise. In addition, with ISOs, the tax on such increased value can be paid at the preferential long-term capital gains rates, rather than the higher ordinary income rates, depending upon how long the underlying shares are held after ISO exercise (although the paying corporation would not be entitled to any compensation deduction for the value of the gained realized on sale of the shares underlying such ISOs). This is quite a difference from non–ISO options, or non-qualified options (“NQOs”), where the holder of the NQO is required to recognize ordinary compensation income on option exercise equal to the difference between the option exercise price and the fair market value of the underlying shares on the date of option exercise itself. Any tax payable on that gain is not deferred until the underlying shares are sold—resulting in the potential for a tax payment when there are no proceeds from the sale of the underlying shares to defray the tax. Finally, with NQOs, if the NQO holder is an employee – rather than an independent contractor –the gain recognized on option exercise constitutes “wages” with respect to which the company would be subject to withholding/payroll taxes.
A Founder of a corporation can also be compensated post-funding with “restricted stock”. Restricted stock awards are made without associated payment by the Founder recipient and can be made under the same Plan as ISOs. In general, a recipient of restricted stock must recognize ordinary compensation income when such stock vests, or immediately upon grant for the portion of such stock subject to an 83(b) election. The value of the award subject to tax equals the vesting date fair market value of the portion of the restricted stock that vests (or, in the case of an 83(b) election, the grant date fair market value of the entire grant). Such fair market value could be determined by reference to a recent arms-length equity or debt funding event for the company. If the restricted stock award vests over time – and no 83(b) election is filed– then the Founder would recognize ordinary compensation income on the vesting date (and the company would have a corresponding withholding and employment tax obligation in respect of such income) equal to the fair market value of the restricted stock that vests on that vesting date. Accordingly, this can create the “perverse” situation in which the Founder’s successful efforts to increase the company’s enterprise value could have an adverse “economic” impact by causing a corresponding increase in restricted stock valuation (and, thus, a corresponding increase in taxable income liability for the Founder and an increase in withholding and employment tax liability for the company) over the vesting period. The Founder and the company could find themselves in the unenviable position of being unable to sell (or otherwise monetize) a sufficient amount of the vested shares, or otherwise be unable to raise a sufficient amount of cash from other sources, to pay the resulting income tax liability or, in the case of the company, the resulting withholding and employment tax liability.
One means of addressing this increasing enterprise valuation “problem” is for the Founder to consider making an “83(b) election” to pay immediate tax on the value of the entire restricted stock award at the time it is granted, even though the entire award may never vest. By making this election the Founder would have only a single compensation tax event in respect of the restricted stock award, with the Founder immediately recognizing ordinary compensation income equal to the fair market value of all the restricted stock subject to the award determined without regard to the vesting to which the stock is subject. The Founder and the company would have an immediate compensatory tax event as a result of the election, and would need to have sufficient cash to pay the resulting income and withholding and employment tax liabilities, as applicable, at a time when cash may be in short supply for both the Founder and the employer-company. The subsequent vesting of the restricted stock in accordance with the original terms of the award would not be a tax event and the Founder would only recognize additional income in respect of such stock upon the actual sale of the stock (to the extent of any gain above the fair market value of the shares on the date of the original award). Any resulting taxable gain from such sale would constitute preferential long-term capital gain (rather than ordinary income) if the shares are held for more than one year from the date of the award. However, the downside of making the 83(b) election for a restricted stock award includes: (a) the Founder would not be entitled to claim any loss deduction (or otherwise have any refund claim) on any of the previously-paid income tax if the shares do not vest; and (ii) the Founder may only recover any decline in value of any non-forfeited restricted stock as a capital loss (even though the Founder would have paid tax at ordinary income tax levels by making the 83(b) election).
Finally, if the Founder’s business is being conducted as a “limited liability company” (rather than as a corporation), a Founder can be compensated by being issued a “profits interest” in the limited liability company— a specially designed economic interest in a company’s profitability. Under current IRS guidance, such a “profits interest” could be issued free of income tax and withholding/employment taxes. In addition, since such a “profits interest” would constitute an interest in the limited liability company, the Founder would be taxed on, or receive a deduction equal to, his/her allocable share of the limited liability company’s income and gain or loss, as applicable. Also, except for the Founder’s share of certain assets of the limited liability company, the Founder would recognize preferential long-term capital gain if the “profits interest” was held for more than one year prior to its sale. That said, however, it should be noted that Congress is currently considering legislation that could subject certain types of “profits interests” to ordinary income treatment (e.g., carried interests in private equity funds).
Question provided by Dean Collins – (LinkedIn, @deancollins), Director of Cognation and Live Chat Concepts.
Answer provided by Peter Rothberg – (website, LinkedIn @FatherR), Partner at Duane Morris, Ultra Light Startups sponsor and counsel.
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