Sec. 83 Risks when Compensating Founders in a New Venture

Co-Editors: Michael Metz, CPA; Nick Gruidl, CPA, MBT

The founders of a new venture are often entrepreneurs who have the ideas and relationships to start and create a successful venture, but not the capital to sustain and develop it. Venture capitalists, private-equity funds and public markets satisfy the needs of the new venture and its founders. However, whether at inception or at a later date, capital infusions are not without their tax pitfalls. When the founders, in exchange for bringing investors into their venture, receive a large equity interest in exchange for a relatively small capital contribution, Sec. 83 could require them to recognize substantial ordinary income. A common solution is the use of a partnership or limited liability company (LLC) and the issuance of profits interests to alleviate Sec. 83’s effect. However, in many cases, the LLC does not enjoy the same access as corporations to the capital markets, so the Sec. 83 risks remain substantial for many start-up ventures.

Overview

In general, Sec. 83 applies to a transfer of property in connection with the performance of services. Stock issued in connection with services is compensatory and requires the recipient to recognize ordinary income, to the extent the value of the property received exceeds that of the consideration given; see Sec. 83(a). When stock received in a compensatory transfer is subject to a substantial risk of forfeiture, the receipt is taxable only when that risk lapses. However, the recipient will recognize ordinary income on any appreciation between the date of the initial transfer and the risk’s lapse. The recipient may elect under Sec. 83(b), within 30 days from the date of the transfer, to be taxed in the year of transfer rather than waiting until the property is fully vested and recognizing the appreciation as additional compensation. If the issuance is not made in connection with the performance of services, it is capital in nature.

Performance of Services

For Sec. 83 to apply, the property must have been transferred “in connection with the performance of services.” A transfer is subject to Sec. 83 whether in connection with past, present or future services; see Regs. Sec. 1.83-3(f). Neither Sec. 83 nor Congress has specifically addressed what constitutes a transfer in connection with the performance of services. The courts have generally held that Sec. 83 was intended to apply broadly; see Alves, 79 TC 894 (1982), aff’d, 734 F2d 478 (9th Cir. 1984). The Ninth Circuit has stated that “Congress made section 83(a) applicable to all restricted ‘property’ not just stock; to property transferred to ‘any person,’ not just to employees; and to property transferred ‘in connection with…services’ not just compensation for employment.” Thus, for Sec. 83 to apply, a relationship must exist between the services performed and the property transferred; see Montelepre Systemed, Inc., TC Memo 1991-46, aff’d, 956 F2d 496 (5th Cir. 1992).

To determine whether such a relationship exists, the courts look to all facts and circumstances, and generally apply the following four-factor analysis, with no one factor controlling: (1) whether the property right was granted at the time of employment or initial association as an independent contractor, (2) whether property restrictions are linked to employment or tenure as a contractor, (3) whether the property was transferred in consideration for the performance of services and (4) the transferor’s intent. See Montelepre Systemed, Inc.; Centel Communications Co., 92 TC 612 (1989), aff’d, 920 F2d 1335 (7th Cir. 1990); Bagley, 85 TC 663 (1985), aff’d, 806 F2d 169 (8th Cir. 1986); and Alves.

Example 1: A and B, founders, along with P, a private-equity or venture capital group, form X Corp. in a transaction to which Sec. 351 applies. A and B together contribute $20 for a 20% stake (20 common shares). P contributes $800 for an 80% stake (80 common shares). A and B are both key employees of X and operate the business on a daily basis. In addition, A’s and B’s shares may or may not be subject to a substantial risk of forfeiture.

In all likelihood, under the four-factor analysis, the transfer of shares is in connection with services performed by A and B for X. Under Sec. 83(a), A and B will recognize ordinary income to the extent the fair market value (FMV) of the stock received exceeds the amount paid. A and B received a 20% stake in X for $20. At the time of that transfer, X was worth $820 (or, perhaps, $1,000 ($800/80%)). Thus, A’s and B’s 20% stake is worth $164 (or $200), and they must recognize income of $144 (or $180); see Levin, Structuring Venture Capital, Private Equity and Entrepreneurial Transactions (Aspen, 2006, ¶201.1.1. X will be able to take a $144 compensation deduction. As a start-up venture, X likely has no income to offset losses, which will be deferred until the corporation becomes profitable.

Example 2: P contributes $800 for 80% of X’s common shares, but does so six months after X’s incorporation. If, at the time of incorporation, there was no binding agreement between either A and B or X and P for P’s subsequent investment, and the step-transaction doctrine does not apply, each investment should be looked at separately.  

Presumably, during the first six months of operation, A and B began to develop X and laid the groundwork for a successful venture. Assume that A and B formed X to expand their operations through a “roll up” of multiple targets in a growing new industry (e.g., alternative or renewable energy), with the thought of eventually going public. Within the first six months, they may have identified and negotiated with targets and lenders; however, X needs P’s investment to complete the transaction. Thus, when P enters X, the company is worth considerably more than six months earlier. A and B argue that P paid FMV for the X stock (as a result of arm’s-length negotiations), and there was no transfer of value to the founders; see Levin, ¶201.1.2(2).

On formation, X was (in theory, at least) worth only the $20 A and B contributed. Thus, assuming the stock is not restricted, regardless of whether the X shares were received in connection with the performance of services, the transfer should be nontaxable; the value of the property received equals the amount paid for it. However, following P’s investment and the roll-up, A and B’s 20% interest is worth substantially more than the $20 they invested.

Taxpayers and tax advisers should be wary; any determination like this is strictly on a facts-and-circumstances and valuation basis, which carries with it the risk of audit and hazards of litigation.

Subsequent Restrictions

Example 3:  The facts are the same as in Example 1, except that when P invests, restrictions are placed on A’s and B’s shares. (This is not an uncommon practice, because X’s value depends in large part on A and B.) The restrictions protect P’s investment until certain performance measures are met or X goes public. The restriction may be tied to A’s and B’s employment and, thus, appears to be in connection with the performance of services.

However, the IRS has ruled in similar situations that subsequent restrictions on already fully vested shares cannot cause Sec. 83 to apply to the transaction. In IRS Letter Ruling 200212005, the Service ruled that subsequent restrictions placed on fully vested shares did not cause Sec. 83 to apply, as there was no property transfer; thus, a vesting restriction subsequently placed on fully vested shares should not cause a Sec. 83 event; see Rizzi, “Equity and Quasi-Equity: The Impact of Section 83 on Reorganization in the Technology Section,” 29 Corp. Tax’n 5 (September/October 2002). 

Example 4: The facts are the same as in Example 1, except that P receives preferred (rather than common) stock in the transaction (as is normal with private-equity-fund investments). P invests $800; A and B invest $20. However, P receives 80 shares of preferred stock that carry a liquidation preference, cumulative dividend and an “as if common” feature after payment of the cumulative return, while A and B receive 20 shares of common stock. In the event of an initial public offering, the preferred stock converts to common and any cumulative accrued dividends are lost. The contention would be that P’s preferred stock is worth far more than A’s and B’s common stock, and A and B received property with a value equal to the consideration paid for it.

Just as in Example 2, this position is a facts-and-circumstances analysis and a valuation issue. The concern is that the common shares receive a substantially disproportionate share of future appreciation, similar to the value of an option privilege.

Conclusion

While there are Sec. 83 risks associated with equity issuances to founders in a start-up venture, proper planning should allow founders to realize the benefit of their “sweat equity” in capital, rather than compensation.