Startup Tax Issues (Part 1):
“Avoiding Frustration on the Way to Success”
Tax can be intimidating. The rules are complicated, subject to change, and frequently poorly written. Tax is also as unavoidable as death and that other thing. The good news is that early stage startup taxation is a relatively limited field: four topics make up about 60-80% of the tax issues with which a founder will have to deal. Put differently, if you are familiar with these four issues, by the time you need to know much more, your company will have someone else deal with it for you.
This series of blog posts will address these four topics: common stock valuation, 83(b) elections, entity selection, and state taxation.
Common Stock Valuation
Founders are usually aware of the valuation issues associated with preferred stock financings. The question of common stock valuation, however, is a different issue. Failure to issue options with an exercise price at least equal to the fair market value of the underlying stock will result in tax penalties to the recipient of the options, which would undermine the company’s equity compensation plan. So-called “409A” valuations should generally be undertaken at least every 12 months, and immediately following each equity financing.
Common stock valuation questions arise in the context of option grants as equity compensation. Briefly, options are a right to purchase shares of a company at a set price (the “exercise price”). Options are typically granted to those who provide services to the company including employees, directors and certain consultants, and are usually rights exercisable for the company’s common stock. Options allow a service provider to share in the growth of the company’s equity value. Options are typically subject to vesting restrictions; that is, the options are exercisable as to a gradually increasing number of shares over the period of time associated with the service provider’s service to the company. The purpose behind the structure of options is to encourage service providers to work harder for the company in the hopes of recognizing additional value when the company experiences an exit event (e.g., a sale, merger, public offering, or similar transaction).
Types of Options
There are two types of options: incentive stock options (“ISOs”) and nonqualified stock options (“NQSOs”). ISOs are granted to employees, while NQSOs can be granted to anyone, including non-employee service providers (e.g., advisory board members, consultants, etc.). Provided the requirements for qualification of an ISO are satisfied, generally employees are not taxed at the time of grant or exercise (unless the alternative minimum tax applies). When the stock underlying the ISO is sold, gain or loss (that is, the difference between the sale price and the exercise price) will be capital in nature. Similarly, NQSOs are not taxed to the service provider upon the grant (provided the company is not a public company), but upon exercise, the service provider will recognize ordinary income equal to the difference between the fair market value of the shares and the exercise price.
Qualifying an Option as an ISO
Aside from the fair market value issue discussed below, ISOs are subject to a number of requirements, including the following:
- ISOs must be granted under an option plan that has been adopted by the company’s board of directors and approved by the company’s stockholders;
- ISOs are subject to a $100,000 vesting limit per year per optionee; anything over the limit is treated as an NQSO; and
- ISOs cannot be granted to a stockholder that holds 10% of the voting power of the company.
Subject to the fair market value discussion below, NQSOs are not subject to these requirements.
For both ISOs and NQSOs, the option exercise price cannot be less than the fair market value of the underlying stock at the time of grant. Options that otherwise would qualify as ISOs with an exercise price under fair market value will be treated as NQSOs, and NQSOs with an exercise price under fair market value will be subject to the penalty provision of Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”). Under this penalty provision, the service provider who receives the options will face immediate taxation on each vesting event, as well as a 20% penalty. The company will have certain withholding obligations, and, as a result of the penalties, its equity compensation plan will be undermined. Similar state tax penalty provisions may apply as well.
In order to avoid these 409A penalties, a non-publicly traded company should undergo regular “409A valuations.” These valuations must involve the “reasonable application of a reasonable valuation method.” Depending on the stage of the company’s growth, a full third-party valuation may not always be necessary, but the valuation must be made in accordance with certain requirements of the Code and applicable Treasury regulations, and the company should consult its legal counsel and financial advisors. Generally, a valuation should take place at least once every 12 months and immediately following any equity financing.