How to Avoid Tax Penalties on Startup Employee Compensation
Startup and growing companies often use deferred compensation as an effective way to attract and retain important employees. Unfortunately, this process has been complicated by a recent tax change that significantly penalizes a broad range of “non-qualified” deferred compensation plans. Under Section 409A, deferred compensation which does not meet certain requirements is immediately taxable to the recipient and is subject to significant penalties. In order to avoid the penalties associated with this provision, startup companies should ensure that any deferred compensation meets IRS requirements.
Although Section 409A applies to many types of deferred compensation, stock option compensation is the most commonly implicated. Deferred stock option compensation is not subject to Section 409A penalties if the strike price (or exercise price) is greater than, or equal to, the fair market value of the shares on the grant date. Failure to set an appropriate strike price will subject the stock option recipient (employee) to the penalty provisions of 409A. The penalty provisions provide that the recipient of non-compliant stock options will: (1) be taxed at ordinary income tax rates for the value of the deferred compensation, (2) pay an additional twenty percent penalty, and (3) be subject to significant late payment penalties. Employees will, understandably, not be very happy about paying all of these extra taxes. Furthermore, the company may be subject to employee lawsuits for failing to set an appropriate option price.
Since the consequences of setting the strike price below fair market value are severe, you may be wondering how fair market value is calculated for your company’s stock. The IRS has provided several methods for complying with the strict requirements of Section 409A. Although compliance can be achieved through other means, there are three valuation methods that, if followed, create a presumption that the calculated fair market value is reasonable.
Independent Appraisal Presumption
The requirements under the Independent Appraisal Presumption are fairly straightforward. To fall within this presumption, the company must hire a qualified independent appraiser to value the company’s shares. The valuation provided by the independent appraiser is valid for a period of 12 months unless a subsequent event occurs which has a material effect on the company’s stock value. Examples of significant events might include a proposed merger or new equity financing. One downside to this method is the potential cost of hiring an independent appraiser. The upside is that an independent appraisal serves as an insurance policy against a subsequent IRS challenge. When selecting an independent appraiser it is important to ascertain that they are “qualified”. The surest way to do that is to select a professional that has certification credentials from one or more of the four national organizations that provide education and certification credentials for business valuation professionals. They are the National Association of Certified Valuation Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBI) and the American Association of Appraisers (ASA). Selecting a professional that specializes in 409A valuations is also a good idea and may help keep fees to a minimum.
Formula Valuation Presumption
The Formula Valuation Presumption is only applicable for a narrow range of companies. To use this presumption, the company must already have in place a binding formula for determining the sale price of stock to other parties. For example, if a company’s stock had a permanent limitation which required the holder to sell or offer the stock according to a specific formula (e.g. a buy-sell agreement between the shareholders), that formula could be used to create a presumption of fair market value. These formulas are often based on a multiple of book value or earnings (or a combination of the two). However, if the shares may be sold or transferred in any way other than according to the formula, then this presumption is not available.
Illiquid Startup Presumption
Since startup companies are often difficult to value, the IRS has provided a special presumption for the stock of these illiquid companies. As long as certain requirements are met, the IRS will consider a valuation of startup company stock to be reasonable. However, if the company has any public stock or has been in business for more than 10 years, this presumption is not available. Furthermore, the valuation must be performed by a person with significant experience performing similar valuations and must be evidenced by a written report. But, unlike the Independent Appraisal method, the startup company does not need to hire a third party to perform the valuation (the startup may use in-house personnel as long as the relevant requirements are met). Since in-house personnel may conduct the valuation as long as they are qualified, this method is often cheaper than hiring an independent appraiser. For a full understanding of the requirements pertaining to this presumption, you should consult an attorney.
Deferred compensation in the form of stock option grants can be a powerful and effective tool for motivating and retaining startup employees. However, you must ensure that the strike price is set at, or above, fair market value to avoid significant penalties under Section 409A. By using one of the three presumptive methods for calculating fair market value, you place the burden on the IRS to prove that your valuation is unreasonable. Conversely, if you do not follow one of the above methods, you bear the burden of proving to the IRS that your valuation is reasonable.
An attorney experienced in this area can help you determining the best approach for your company by advising you of the myriad of practical and legal considerations as well as the associated costs and the risks.
Tax Traps Associated with Founder’s Restricted Stock
Startup companies often seek to retain their founders and critical employees through the use of equity compensation. To ensure that these top people are committed to the company for the long-term, it is often a good idea to issue stock subject to buy-back provisions (founder’s restricted stock). However, shareholders must be careful to follow strict IRS guidelines to ensure their investment receives the most favorable tax treatment.
A typical founder’s restricted stock transaction grants the founder (or employee) stock compensation but reserves a right for the corporation to buy back any stock that is “unvested.” Initially, most of the stock is unvested, giving the corporation the ability to buy back the stock if the employee leaves. Each year a percentage of the stock initially granted to the employee “vests” and the company loses its right to repurchase those shares. Eventually, if the employee remains with the company, all of the restricted stock will vest.
The shareholder can elect to have his shares taxed in one of two ways by either filing or not filing what is called an 83(b) election. First, if no election is made, the value of the restricted stock is not taxable to the recipient until the stock vests. Once the restrictions lapse, the current fair market value of the shares, minus any amount paid for the shares, is taxable as ordinary income in the year the stock vests. Alternatively, under Section 83(b) of the Internal Revenue Code, the shareholder can elect to be taxed on the value of all shares (including unvested shares) at the time of receipt. Although each option has its benefits, there are several factors that weigh in favor of making the 83(b) election.
The table below briefly summarizes the relevant aspects both choices:
With 83(b) Election
• Value of restricted stock (minus any payments for the shares) is taxable as ordinary income in the year shares are received.
• Share appreciation is taxed upon sale at capital gains rates.
• Dividends on all shares are taxed at the preferential dividend tax rate.
• No deduction is allowed if share value decreases.
• Shareholder controls timing of gain recognition (upon sale of shares).
• Holding period begins upon receipt of shares.
Without 83(b) Election
• Value of restricted stock is not included in income until the restrictions lapse (the stock “vests”).
• Share appreciation is taxed at ordinary income rates and is recognized when the shares vest. This can cause problems for the founder because he may incur substantial tax liability but not be able to sell the stock to generate the cash to pay the taxes.
• Dividends on restricted shares are taxed as compensation (but are deductible to the corporation).
• Shareholder does not control timing of gain recognition (taxed as ordinary income on value of shares once stock vests).
• Holding period does not begin until the share restrictions lapse (the stock “vests”).
The ideal scenario for an entrepreneur to make an 83(b) election occurs when the founder pays fair market value for the restricted stock, and the share value is expected to increase over time. This situation leaves the shareholder paying no or minimal tax upfront, but enables the shareholder to control the timing of future gains (upon the sale of stock) and affords capital gains treatment rather than ordinary income. Getting an attorney involved at the time of company formation can ensure that the founders can take advantage of this tax planning opportunity.
If you decide that making an 83(b) election is right for you, then be sure to file the appropriate notice with the IRS within 30 days of the receiving the restricted stock—there is no grace period. The IRS does not provide a specific form, but the election must be in writing and filed with the Internal Revenue Service Center where you file your return. IRS Publication 525 provides specific details regarding 83(b) elections.
You should get in contact with your attorney if you have questions about whether the issues discussed in this post apply to your or your employees’ compensation arrangements.
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