Tag: Lex Noa Law

Startups

Startup Founders Don’t Need To Make A Section 83(b) Election

On By crowdfundattnyIn Crowdfunding, Startups2 Comments

A bunch of websites, including websites of large law firms, advise startup founders to make an election under section 83(b) of the Internal Revenue Code. They shouldn’t have relied on ChatGPT! For almost all startups and almost all founders, a section 83(b) election is unnecessary and foolish.

Section 83 is captioned “Property Transferred in Connection with Performance of Services.” Section 83(a) states the general rule:  if you receive any kind of property in exchange for performing services you have to pay tax on the value of the property. The property could be anything, an old car, a 17th Century Chippendale cabinet, Bitcoin, but in the world of startups the property is usually company stock.

Under section 83(a), if you’re hired as the CTO of Startup, Inc. and receive 10,000 shares of Startup, Inc.’s stock as as part of your compensation package, worth $1.00 per share, Box 1 of your W-2 will include that $10,000 of value, along with your very modest cash salary.

When startups hire CTOs and other service providers, they structure the compensation package so the CTO will stick around. Typically, Startup, Inc. would give you the 10,000 shares today but provide that they “vest” in four tranches, 2,500 today, 2,500 at the end of the first year, 2,500 at the end of the second year, and 2,500 at the end of the third year. If you leave at the end of the second year you own 7,500 shares while the other 2,500 shares disappear.

Section 83(a) says you don’t pay tax on the shares until they vest. So you’d pay tax on the first 2,500 shares this year, then pay tax on the second 2,500 shares next year, and so forth. That’s great! You don’t have to pay tax on the property you receive until it’s vested or, in tax code parlance, until it is no longer “subject to a substantial risk of forfeiture.” 

That’s very fair but in the startup world there’s a downside. You think the shares of Startup, Inc. are worth $1.00 today but you hope they’ll be worth way more in the future – that’s the whole point of the startup. And while section 83(a) allows you to postpone paying tax until your shares vest, the flip side is you pay tax on the value at the time they vest. If the shares are worth $1.00 today you pay tax on $2,500 this year. But if they’re worth $1.65 next year you pay tax on $4,125. And if they’re worth $3.30 the year after you pay tax on $8,250, up and up.

That’s where section 83(b) comes in.  By filing a piece of paper with the IRS – the section 83(b) election – you can choose to pay tax on all the shares today, even on the shares that aren’t yet vested, at their current value, rather than paying tax on the value in the future.

You’re making a bet. If you’re confident the company will succeed, you choose to pay tax on $10,000 today even though you don’t really own all the shares and only have to pay tax on $2,500, hoping to save a lot of tax in the future. If the company fails you lose your bet:  you’ve paid tax on $10,000 of shares that weren’t really worth anything. 

As you might have noticed already, the whole scenario has nothing to do with founders, for two obvious reasons:

  • Leah, the founder of Startup, Inc. didn’t receive her stock by promising to perform services in the future. She received her stock because she formed the company. She transferred to the company the idea for the business, her marketing plans, a little cash, a contract with her first customer, maybe some computer code or other property. In tax parlance she contributed the goodwill.
  • Leah didn’t make her own stock “subject to a substantial risk of forfeiture”! She formed the company and issued all the stock to herself. Period.

For those of you keeping track, the issuance of stock to Leah by her company was tax-free under section 351 of the Code because she owns more than 80%.

The situation I just described is true of about 99.8% of startups. In the other .02% of cases, perhaps a founder teams up with an investor before forming her company and agrees that some of her stock is subject to a vesting schedule. In those cases, and only in those cases, would section 83(b) be relevant.

If your main challenge as a founder is you don’t have enough stuff to file with the IRS, go ahead and file a section 83(b) election even though it’s unnecessary and meaningless. Otherwise spend your time on something else.

Be careful what you read on the internet!

Questions? Let me know. 

LLC Vs C Corporation For Startups: A Short Explanation

On By crowdfundattnyIn C corporations, LLCsLeave a comment

Like COVID, the questions around choosing a limited liability company or C corporation for startups never seem to go away.

For lots of details see the article I wrote here. Except for making you the center of attention at the party, however, those details don’t matter very much. So I’m offering this short version.

In a limited liability company you pay only one level of tax upon a sale of the company, while with a C corporation you pay two levels. That can make an enormous different to the IRRs of founders and investors.

Yet many startups are formed as C corporations. Why?

In Silicon Valley successful startups are funded by venture capital funds. Indeed, the most common measure of “success” in Silicon Valley is which venture capital funds have funded a startup, for how much, and how many times.

Venture capital funds are themselves funded, in part, by deep-pocketed nonprofits like CALPERS and Harvard.

All nonprofits are subject to tax on business income, as opposed to income from their nonprofit activities. For example, Harvard can charge a billion dollars per year in tuition without paying tax, but if it opens a car dealership it pays tax on the dealership’s profits. The car dealership income is called “unrelated business taxable income,” or UBTI.

Now suppose Harvard owns an interest in a VC fund, which is structured as a limited liability company or limited partnership (as all are). If the VC fund invests in an LLC operating a car dealership, then the income of the dealership flows through first to the VC fund and then from the VC fund to Harvard, where it is again treated as UBTI, subjecting Harvard to tax and reporting obligations.

Harvard doesn’t want to report UBTI! So Harvard tells the VC fund “Don’t invest in LLCs or partnerships, only C corporations, where the income doesn’t pass through.” And because Harvard writes big checks, the VC fund does what Harvard wants.

That’s why the Silicon Valley ecosystem uses C corporations. Everyone knows about the extra tax on exit, but everyone is willing to pay it on exit to get the big checks from Harvard.

I will pause to note that in many cases the nonprofit’s concern about UBTI is illusory. Many startups never achieve profitability, including startups sold for big numbers. So there would never have been any UBTI in the first place.

(Yes, I know that there’s no extra tax in an IPO or tax-free reorganization, but those are small exceptions to the general rule.)

Because Silicon Valley is the center of gravity in the American startup ecosystem, like the black hole at the center of the Milky Way, it exerts a force that is not always rational. Many investors, including funds with no nonprofit LPs and hence no possibility of UBTI, will tell startups “I only invest in C corporations,” simply based on the Silicon Valley model.

This creates a dilemma for founders, especially in the Crowdfunding space. If I’m an LLC and list my company on a Reg CF platform, how do I know I’m not losing investors who think, irrationally, that they should only invest in C corporations?

In any case, that’s where we are. LLCs are better in most cases because of the tax savings on exit. But because of the disproportionate influence of the Silicon Valley ecosystem in general and deep-pocketed nonprofit investors in particular, many investors and founders think they’re supposed to use C corporations.

Questions? Let me know.