Avoiding Tax Pitfalls When Issuing Stock

If you take a few legal precautions at the outset, you and your employees can sidestep some painful tax consequences

By
Tom Taulli

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.

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