In other words....how not to give away too much of your company to slackers and flakers who don't deserve it.

Every aspiring start-up founder and founding team should give this a quick read.   Click here for the full post.

In the case of tax distributions, once the shares are issued, the holder will have to pay tax (to the extent that there are taxable profits) pro rata in accordance with his ownership. So, it seems logical that any distributions made to help stockholders pay this tax should also go to the holder of restricted stock on a pro rata basis. If they do not, then the holder of restricted stock will have taxable income and no cash to pay it. Moreover tax regulations require that “S” corporations make all distributions pro rata to all shareholders, including holders of restricted stock (if they have made 83(b) elections), otherwise the IRS could treat the corporation as having an impermissible second class of stock, resulting in loss of the “S” election."

Now, what about the build up of after-tax value in the corporation? A pro rata amount of that build up belongs to the holder of restricted stock. By way of example, if the company makes $1mm of profit and distributes $400K to the stockholders to pay tax liability, there will be $600K of post tax dollars in the company. If the company were dissolved, these post tax dollars would go pro rata to the stockholders. (In the case of an option holder in an “S” corporation, there would be no ownership and no tax burden.) So, when it comes time for a distribution, even if the option holder exercises his options, he does not get the benefit of the after tax dollars – that is to say, he does not take the dollars out tax free. (Nonetheless, the tax regulations described above require that an option holder who exercises his options must share pro rata in any distributions. In this example, if the company distributes the $600K of accumulated post-tax profits, a pro rata portion of the $600K would go the option holder who had exercised his options, even though none of the $600K has been taxed to him. This, of course, reduces the amounts distributable to the other stockholders, so that they would not receive their full pro rata portion of the $600K based on their ownership prior to the option exercise.) Compare this to a holder of restricted stock with reverse vesting. The holder of restricted stock will have incurred taxable income, will have received cash from the company to pay the tax, and will then get a distribution of post tax dollars equal to (in our example) his pro rata share of the $600K.

There is a lot of downside to failing to make the correct filings in the context of restricted stock. You need to seek appropriate advice whenever you get restricted stock.

Here is the post:

A situation that commonly arises in connection with venture financings is when a founder is required to subject some or all of his or her shares to vesting as a condition to obtaining funding. Folks in our tax department note, and I agree, that:

there may be some confusion as to whether a protective 83(b) election should be filed in the situation where a founder receives company stock that is not subject to vesting, and vesting is subsequently imposed at the request of investors. 

Based upon Rev Rul 2007-49, our tax department's position is that:

 such an election is not required, as a general matter, where vesting is imposed on already-owned founders stock. 

But, our tax folks note that:  

A potential exception to this general rule is the situation where vesting is imposed shortly after the stock is first transferred.

In this situation, you need to consult your tax attorney. Our tax folks further note that:

the Rev Rul expressly holds that an 83(b) election is required (in order to avoid tax at the time of vesting) where stock is exchanged for unvested stock of the acquirer in either a tax-free reorganization or a taxable acquisition.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

This arrangement is great, except that it creates a new tax problem. Under the tax code, if Jane does not make an 83(b) election (which we will get to shortly), Jane must take the value of the stock she has been granted into income at the time that the company’s right to repurchase it has lapsed. As a result, Jane will have income equal to the fair market value of 6,250 shares each quarter.

So, let’s assume that on the date of the initial grant the per share value of the stock is $.01 but that at the first anniversary of the grant, the company has developed its business and finds an angel investor who pays $.10 per share and furthermore, let’s assume that on the second anniversary the company has further developed its business and finds an angel investor who pays $1.00 per share. As the shares increase in value, the company has increasing amounts of income to report on Jane’s W-2, for which she has to pay taxes. What was once $1,000 of income, could now be much much more. If the company is really successful, Jane will owe more in tax than she can reasonably pay, and at a time when there is no public market for the stock so she can’t sell shares to raise the money to pay the taxes.  (And keep in mind that all of the income we have been talking about to date is taxed as ordinary income, not capital gains.)

Having said all that, the IRS permits Jane to take all the stock into income (even if it is subject to the company’s right to buy it back) in the year in which it is given to her if she makes an 83(b) election. This election involves filing a form with the government and sending a copy to the company. This form must be filed within 30 days of the grant. In our example, Jane would make the election at the time of the stock grant and would recognize $1000 of income, representing all 100,000 multiplied by their then fair market value of $.01 per share. If Jane expects that the value of the stock of Easy Company will rise, then this is a no brainer. She takes the stock value into income and pays the ordinary income tax on the $1000 of income. This way she begins the capital gains holding period and gets capital gains treatment (on any subsequent increase in value) when she eventually sells the stock in a liquidity event.

This is all well and good, but what happens when two years pass and the stock is now worth $1.00 per share and the company wants to make another grant? The same analysis applies, only now there would be $100,000 of income at the time of grant – assuming Jane made an 83(b) election. At this point stock grants no longer look so desirable. As a result, the company should start using stock options, which do not result in taxable income at the time of grant.

I think it is fair to say that most, perhaps all, entrepreneurs have heard of options.  But, just in case, options are contractual rights to purchase shares of stock (usually common stock) at a fixed price.  In the employment context, options typically vest over time.  For example, four year vesting is a common provision in a venture financed company.  A typical arrangement would be for options to vest 1/4 on the first anniversary of employment  and 3/4 ratably (monthly or quarterly) over the subsequent 3 years.  This is the arrangement included in the National Venture Capital Association form of Term Sheet. Vesting refers to the right to exercise the option and purchase stock at the option price.  Since the employee cannot exercise options unless they are vested, to the extent that options have value, the employee is motivated to remain with the company and realize that value.

Restricted stock is actual stock (as opposed to options which are a right to acquire stock).  Restricted stock can be made to provide an incentive similar to that of options by requiring, as a condition to the grant of restricted stock, that the employee receiving the restricted stock enter into an agreement providing for "vesting."  In the context of restricted stock, it is often referred to as "reverse vesting" and it works like this:  The employee is granted shares of common stock subject to the condition that the company will have the right to buy back the shares at a trivial price (often par value).  The concept of reverse vesting comes in because the company loses its repurchase rights over time.  So, on the first anniversary of employment the company may loose the right with respect to 1/4 of the shares and so on.  In this way restricted stock mimics options.

Having said all this, there are important tax differences between options and restricted stock.  Options can be incentive stock options or non-qualified options.  Incentive stock options are options that meet certain requirements set forth in the internal revenue code and, if all conditions are met, can provide the option holder with capital gains treatment (as opposed to ordinary income treatment) upon the sale of stock acquired through the exercise of these options.  Among the requirements are that the options be held for at least one year and that the stock acquired upon exercise of the options be held for at least one year.  Since most option holders commonly sell the stock they acquire promptly upon exercise of the option, they rarely achieve capital gains on the excess of the sale price of the stock over the exercise price of the option.  Non-qualified options do not provide the possibility of achieving capital gains treatment on the excess of the sale price of the stock over the exercise price of the option (although you might, depending on how long you hold the stock, achieve capital gains on the difference between the fair market value on the date of exercise of the non-qualified option and the eventual sale price of the stock).

With respect to restricted stock, the holding period for capital gains treatment begins upon the date of grant, if the holder files a so-called 83(b) election under Section 83 of the Internal Revenue Code.  As a result, most employees who are granted restricted stock will achieve capital gains treatment.  The dark lining on this silver cloud, however, is that when you file an 83(b) election you must take the then fair market value of the stock into income (for purposes of income tax) without regard to whether or not it is vested.  So, if the stock has a high value, the employee receiving the stock will have a lot of income and no cash to pay the tax.  If the 83(b) election is not made, then the employee has to take into income the fair market value of each share of stock at the time that it vests.  If the value of the stock is increasing (as with the customary hockey stick projections) you can imagine that the income to be realized could become substantial.  To avoid these situations, use option grants.  However, early in the life of a company, its stock may have little value, with the result that using restricted stock and increasing the odds of getting capital gains upon a sale of the stock may make good sense.