Editor: Anthony S. Bakale, CPA
Equity incentive plans continue to be a way for startup companies to incentivize and retain key executives and founders as well as some rank-and-file employees. These plans are especially popular in the technology and life sciences sectors, where private-equity funds look to protect and develop their investment long term, before they hope to sell or go public. Tax matters are often the last thought in any business decision; however, careful planning upfront is needed to ensure the equity plan satisfies the goal of incentivizing and retaining employees while avoiding any pitfalls under the Internal Revenue Code. Understanding the tax effects, both for the employer and employee, is vital. In-depth explanations of the many types of equity incentive plans have been written extensively and can be found elsewhere. This item seeks to discuss specific considerations for startup or early-stage companies considering issuing the various equity incentives.
Valuation risk is the risk that property, in this case, property received in consideration for services, is overvalued or undervalued. Valuation risk exists in nearly every kind of equity incentive plan. The key determination of fair market value (FMV) can often be subjective in a startup or early-stage company. Methods and models used to value a startup can give wildly different results. The methods used on more established companies, such as revenue multiples or discounted cash flows, do not usually apply to startups, which can be pre-revenue. Often, the value used to issue equity is later discovered to be materially wrong when a funding round or sale occurs. This item discusses valuation risk in three of the more common equity incentive plans: awards, options, and partnership profits interests.
Stock or unit awards received in connection with the performance of services are generally governed by Sec. 83. These awards are income to the recipient for the amount that FMV exceeds the amount paid for such property, measured typically when the awards vest (Sec. 83(a)). The recipient can alternatively elect under Sec. 83(b) to include in gross income the entire amount received on the grant date, regardless of any award vesting schedule. In an 83(b) election, FMV is determined without regard to any restriction to which the award is subject that will lapse in the future. In either scenario, the deemed FMV above any amount paid is income to the employee and a deduction to the company. If awards are valued too low, this creates a potential tax liability for the employee and means the company missed out on some deductions for the higher value of the awards issued. On the other hand, if the awards are valued too high, recipients will have paid too much in taxes.
For options, valuation risk becomes more apparent. Nonqualified stock options (NQSOs) are the most common, as they are subject to fewer restrictions and rules compared to their incentive stock option counterparts. NQSOs may fall under the dreaded Sec. 409A unless a few specific requirements are met, the most relevant for this discussion being "[t]he exercise price may never be less than the fair market value of the underlying stock ... on the date the option is granted" (Regs. Sec. 1.409A-1(b)(5)(i)(A)(1)). As Sec. 409A subjects any amounts it governs to a 20% additional tax, plus interest, it is essential to ensure that options are issued at or above FMV. In Sutardja,109 Fed. Cl. 358 (2013), the IRS determined that the taxpayer's exercise of a company stock option was from a nonqualified deferred compensation plan under Sec. 409A(d) and assessed an additional 20% tax under Sec. 409A(a)(1)(B)(i)(II). The taxpayer and the IRS agreed that, as of the grant date, the option did not have a readily ascertainable market value. The taxpayer then had an uphill battle to establish that his NQSO was not issued below FMV.
Although C corporations remain the most popular entity type for many technology and life sciences startups, limited liability companies (LLCs) taxed as partnerships are also common. With the Biden administration's proposed tax increase on corporations, LLCs may become even more frequently used. A favorite equity incentive in partnerships is the profits interest, where an employee becomes a partner but shares only in the future appreciation of the business. Rev. Procs. 2001-43 and 93-27 provide a safe harbor where the IRS will generally treat the receipt of a profits interest as nontaxable. In Rev. Proc. 93-27, the Service defines a profits interest as any "partnership interest other than a capital interest." Since a capital interest "would give the holder a share of the proceeds if the partnership's assets were sold at fair market value" at grant date, the valuation of the interest granted becomes crucial. The revenue procedures above provide a safe harbor only for a true profits interest (Crescent Holdings, LLC, 141 T.C. 477 (2013)). If the profits interest is issued "in the money," the IRS could step in and recast the profits interest as a capital interest, which is compensation on grant or vesting date under Sec. 83, essentially identical to a unit award as discussed above. Even worse, if the recipient made a Sec. 83(b) election on a purported profits interest that was later recast by the Service as a capital interest, the taxpayer would have a large income event for the FMV of the newly recast capital interest on its grant date.
Even with a proper valuation report that determines the value of an equity plan at a certain moment in time, the IRS will have the benefit of hindsight from any future changes in value. In Estate of Jung, 101 T.C. 412 (1993), the Tax Court stated that "[i]f a prospective . . . buyer and seller were likely to have foreseen [a future sale], and the other activities leading to the liquidation, then those later-occurring events could affect what a willing buyer would pay and what a willing seller would demand as of [the valuation date]." In other words, the IRS or courts can use events that occurred after the valuation date that were known, or reasonably should have been known, on the valuation date to determine whether a valuation is accurate. This possibility can deter companies from issuing artificially low-valued awards, options, etc., to employees, knowing a sale or transaction is right around the corner.
Valuation risk can never be truly eliminated. This is especially true in an early-stage company where valuations can be more subjective. Advising clients to make a small investment upfront on a Sec. 409A or other independent valuation can help stop problems before they arise. Various safe harbors exist, and, most importantly, they can shift the burden of proof to the IRS. In having a proper, well-vetted equity incentive plan in place, startup company owners can focus on growing their business instead of constantly seeking new talent.
Sec. 83(b) elections: The bad and the ugly
As discussed above, elections under Sec. 83(b) allow an award recipient to recognize income on a grant date rather than over the vesting period. Startup companies should provide their employees with access to tax experts to advise them on 83(b) elections and any potential upside or downside. After all, the point of an equity incentive plan is to keep employees happy and retain them at the company for the long term, and an employee's getting an unfavorable tax result would hamper this goal.
In Alves, 79 T.C. 864 (1982), aff'd, 734 F.2d 478 (9th Cir. 1984), thetaxpayer paid FMV for stock of a new corporation in which he was employed. The FMV of the stock was never in dispute, but the taxpayer did not make an election under Sec. 83(b). The taxpayer still held some stock at the end of the vesting period but recognized no income on his tax return. The IRS issued an adjustment, assessing additional tax for the appreciation of the stock at the vesting date over the purchase date. Despite having paid FMV for the shares, by not filing a Sec. 83(b) election at that time, the taxpayer was still required to recognize ordinary income over the vesting period under Sec. 83(a). Recognizing this poor tax result, the Tax Court stated, "[i]t is unfortunate that the petitioner in this case did not elect the provisions of section 83(b)." Upon appeal, the Ninth Circuit stated, "[t]he tax laws often make an affirmative election necessary. Section 83(b) is but one example of a provision requiring taxpayers to act or suffer less attractive tax consequences." Despite acknowledging this was an inequitable result for the taxpayer, the courts sided with the IRS. Had the taxpayer made a Sec. 83(b) election upon purchase of the stock, he would have avoided taxation on the appreciation of the stock from the purchase date. In this fact pattern, there would have been no downside to the taxpayer's having filed a Sec. 83(b) election on the purchase date, as the "excess" of FMV over the purchase price would have been zero. In addition, the election of 83(b) treatment will also start the statute clock running with the return filing that included the 83(b) election and, thus, limit the time the Service has to challenge a valuation. Grants and awards subject to vesting can present the IRS with multiple opportunities to challenge the initial valuation as well as each subsequent valuation as the vesting dates tick off.
In addition to not making an 83(b) election when the employee should have, there is the risk of making an 83(b) election and then subsequently forfeiting the grant or award. Even with a Sec. 83(b) election, the shares or units are not legally vested and can still be forfeited if the employee leaves the company or otherwise violates the award agreement. Sec. 83(b)(1) states that "[i]f such election is made . . . and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture." If an employee makes an 83(b) election and subsequently leaves the company, he or she does not get a deduction for any income recognized on the grant date. Forfeiting the units when leaving the company is different than disposing of the units in, say, a liquidation. In a true liquidation, the employee may have basis in the units from income previously recognized when making the Sec. 83(b) election to claim a capital loss if proceeds received in liquidation are less than previously included 83(b) income.
Although this item discusses two scenarios where 83(b) elections or the lack thereof had a bad result, there are numerous examples of an award recipient's making a proper Sec. 83(b) election, holding his or her award, and ultimately selling for long-term capital gain rates. These scenarios usually do not make it to the courts. Still, startup company founders, employees, and other award recipients should consider both the upside and the downside when deciding whether to make an 83(b) election.
Incentivize and retain
Equity awards must always attempt to satisfy the goal of incentivizing and retaining employees. If an employee is offered stock options but ultimately does not have the cash to purchase the company stock, the mechanism designed to retain the employee is not working. Being aware of employees' cash flow considerations is important, and if employers believe that employees cannot or will not exercise their options, they should consider other equity incentive plans. Employers should invest the time to weigh all relevant factors, including valuation risk, cash flows, and character of income to have a quality equity incentive plan.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.