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.
The Amazon Tax: Online Retailers Required to Collect Sales Tax in Growing Number of States
Many online retailers do not collect state or local sales tax on customer purchases—a significant advantage that may be in jeopardy. Large online retailers, such as Amazon.com, have defended their decision not to collect sales tax by citing a 1992 U.S. Supreme Court decision. In that decision, the Supreme Court said that a state cannot require a company to collect sales tax unless the retailer has a physical presence in the state. However, in the current economic climate, many cash-strapped states are looking for an easy source of revenue. As state legislatures seek to work around the Supreme Court’s decision and to force online retailers to collect sales tax, it is increasingly important to understand the burdens and complexities that these laws impose on online retailers.
Recently, a handful of states have passed legislation that target affiliates of out-of-state Internet retailers. The basic operation of these laws is fairly simple. The laws generally seek a link between the out-of-state online retailer, and an in-state affiliate. The in-state affiliate is often a website, operated by a third party, that promotes the online retailer’s goods or services in exchange for a fee. For many companies, affiliates provide significant web traffic to the retailer’s online site and can drive a meaningful percentage of sales. Even though the retailer does not have a physical presence in the state, if any of its affiliates have an in-state presence, the retailer may be treated as having a sufficient connection to the state by virtue of its relationship with the affiliate. Once an in-state presence has been established, the state will require the retailer to collect sales tax on all purchases within the state.
There are a few limitations however. First, the laws generally provide that the relationship between a retailer and an affiliate must surpass a minimum threshold before the association will subject the retailer to state tax collection laws. For example, in a recently passed Illinois law, affiliates do not create an in-state presence for the online retailer unless the retailer realizes $10,000 in sales from web traffic linked from the affiliate’s site. However, once this threshold is passed, the online retailer must collect state sales tax for sales to all state residents (including sales unrelated to an affiliate). Although the $10,000 threshold amount is the most predominant among legislation currently under consideration, you should consult an attorney to confirm the proper threshold and to ensure compliance with any other local requirements.
Second, many of the laws only create a rebuttable presumption of an in-state presence. Presumably, if an online retailer exceeds the $10,000 threshold for an in-state affiliate, the retailer may still rebut the presumption that it has a presence in the state. For example, an online retailer could demonstrate that the in-state affiliate did not engage in any in-state solicitation on behalf of the retailer.
Because the legal landscape is constantly changing for online retailers, staying informed about state legislation in this area is crucial. A change in a state’s law (where the online retailer has an important affiliate) can create additional accounting and tax remittance burdens for the retailer. If a company has affiliates across many states, the retailer may be forced to determine if the costs of complying with a given state’s sales tax law is worth the revenue earned from sales to that state.
If you are uncertain about your status as an online retailer, or the status of an affiliate, you should consult an attorney for professional advice in this fast changing area of law.
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.
Categorizing Workers: Employees or Independent Contractors
It can be a huge money-saver for a small business to get into the practice of working with independent contractors. Using independent contractors will lower a companies tax bill, require less withholdings, and in some states, reduces the obligations under workers’ compensation requirements. As a result, many small businesses advantageously hire independent contractors and tell such contractors they are responsible for their own taxes.
Some companies push the line, however, and classify as independent contracts many workers who are in fact employees. The IRS is catching on and hoping to catch employers with discrepancies. A new IRS program, launched in early 2010, plans to randomly examine 6,000 companies over the next three years. The purpose of these examinations is to find misclassified employees. This new program makes the decision of how to categorize workers even more important.
In general the status of a particular worker is a product of the facts and circumstances surrounding the worker. A large factor in determining independent contractor status rests in the degree of control the worker has. An independent contractor would seemingly have more control over his or her hours, as well as the manner in which the work is performed. FindLaw, an internet website which compiles legal documents, publishes a twenty-factor checklist to help determine if a worker is an employee or independent contractor. To access this checklist click here.
Employers should think twice before classifying a worker as an independent contractor or employee, or risk writing a big check to the IRS for unpaid taxes, penalties and fines. In addition, an employer that misclassifies workers should be prepared to provide access to benefits retroactively for such misclassified workers. One example of this was the class action federal lawsuit filed against Microsoft Corporation, Vizcaino v. Microsoft Corp., the result of which was Microsoft having to pay approximately $ 97,000,000 to thousands of employees as well as the massive legal bill accumulated during the case.
The lesson is that employers cannot assume that independent contractors are necessarily “independent contractors” simply because that’s what their agreement states. The IRS and state agencies certainly will not be making this assumption. Employers should make an effort learn the rules in their respective state and on the IRS website or consult an attorney. If you want your independent contractor classification to be respected by the IRS, you need to tailor your relationship with your workers so that it meets the guidelines set forth by the IRS.
Looking to Hire?
Franklin County Job and Family Services is offering a Subsidized Employment Program covering between 65 and 100% of a qualified employee’s wages for a period of time (about 6 months). Here’s a link to their website; more information can be found on the PDF’s they link to on the home page.
http://www.franklincountyohio.gov/commissioners/jafs/
Deadline to Contest Real Property Valuations in Ohio is March 31, 2010
In 2009, many Ohio counties reappraised real property and assigned new values that will be used to determine property taxes through 2012. The deadline to contest these valuations in March 31, 2010. While not always cost effective, many owners of high value property are finding that in light of the recent slide in property values, appealing these valuations makes sense. Auditors typically use mass appraisal systems that do not always take into effect localized conditions or even recent sales.
If you own property and feel that your valuation has been adjusted improperly, or not properly reduced given the recent downturn, we can help determine if contesting the valuation makes sense for you.
Individual Liability for Ohio Sales Tax
Simply forming a corporation or an LLC won’t protect you from individual liability if your company fails to pay sales tax it owes in Ohio. Individuals can be held personally liable for the sales tax debts of a company. Further, the dissolution, termination or bankruptcy of a company will not discharge a responsible officer, employee’s or trustee’s liability.
Ohio Revised Code Section 5739.33 states that those individuals, corporate officers or trustees having control or supervision of, or charged with the responsibility of filing returns, making payments, or executing the corporation’s or business trust’s fiscal responsibilities can be personally assessed for the outstanding trust tax debts of the corporation.
State tax liability should not be taken lightly. Entrepreneurs and corporate officers should take care that the required reports are filed and payments are timely made.
Stay Informed
