Startup Company Blog : Seattle Startup Lawyer & Attorney : Davis Wright Tremaine Law Firm : Emerging Companies & Venture Capital

It is very common for a company to hire an employee on a specific date and in the employee's offer letter state that "subject to board of directors approval, the employee will be granted a stock option" to acquire a certain number of shares, "with an exercise price equal to the fair market value of the company's stock on the date of grant."  

What happens if the stock rises in value between the hire date and the grant date?

The option must be priced at the fair market value on the grant date--meaning, the date the board of directors grants the options, in order to avoid potentially adverse tax consequences to the optionee under Section 409A of the Internal Revenue Code.  The hire date is not the relevant date for avoiding potential Section 409A tax problems.

For most private companies the risk of the fair market value of their stock increasing between a hire date and the next board meeting is not too great of a concern, but it can happen.  What is recommended?  Managing new hire expectations with regard to the timing of the grant.  Among other things, include the language above in your offer letters--"subject to board of director's approval, .... with an exercise price equal to the fair market value of the company's common stock on the date of grant."

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LLCs taxed as partnerships as a choice of entity have their drawbacks, which we have discussed elsewhere.  However, LLCs do have one advantage over corporations when it comes to granting equity interests to service providers--they can grant what is know as profits interests to their partners.  

See IRS Rev. Proc. 93-27 and 2001-43.  A profits interest is an interest in an entity taxed as a partnership that entitles the holder to a share of profits in the entity going forward (and no share of the liquidation proceeds if the entity were liquidated immediately after receiving the interest).

The receipt of profits interest is not taxable to the recipient.  This is different from and a more advantageous treatment than the receipt of stock of a corporation by a service provider.  When a service provider to a corporation receives stock, the service provider will have an immediate tax impact if the stock is fully vested or if the service provider makes a Section 83(b) election.  If the stock is not fully vested, the service provider will have a tax impact upon vesting--when the stock may have risen in value.  

The recipient of a profits interest does not have a tax impact upon receipt or vesting.  

(See also IRS Notice 2005-43:  "This notice addresses the taxation of a transfer of a partnership interest in connection with the performance of services. In conjunction with this notice, the Treasury Department and the Internal Revenue Service are proposing regulations under § 83 of the Internal Revenue Code. The proposed regulations grant the Commissioner authority to issue guidance of general applicability related to the taxation of the transfer of a partnership interest in connection with the performance of services. This notice includes a proposed revenue procedure under that authority. The proposed revenue procedure provides additional rules for the elective safe harbor under proposed § 1.83-3(l) for a partnership’s transfers of interests in the partnership in connection with the performance of services for that partnership. The safe harbor is intended to simplify the application of § 83 to partnership interests and to coordinate the provisions of § 83 with the principles of partnership taxation. Upon the finalization of the proposed revenue procedure, Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191, (described below) will be obsoleted. Until that occurs, taxpayers may not rely upon the safe harbor set forth in the proposed revenue procedure, but taxpayers may continue to rely upon current law, including Rev. Proc. 93-27, 1993-2 C.B. 343, and Rev. Proc. 2001-43, 2001-2 C.B. 191.")

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New companies frequently have to confront this issue.  After the founders stock issuances, the founders want to grant stock options to new hires.  Internal Revenue Code Section 409A requires that stock options be granted at fair market value to avoid adverse tax consequences.

But how do you determine fair market value?

The law does not require that companies hire an independent, third party appraiser to value your stock.  You may want to; it may be very helpful to you if you do.  But the law does not require it.

What the law does require is that the valuation be determined by the "reasonable application of a reasonable valuation method." 

In general, we recommend at a minimum that companies make a determination of fair market value based on the value of assets and liabilities on the balance sheet, discounted cash flows if projections are possible, and any third party offers to buy the stock of the company (if available), and the company should keep a record for its own purposes of how it reached its conclusons.  We are of course lawyers and not valuation experts, and companies may want to consult with valuation consulting firms if they do not feel comfortable with their internal capabilities in this regard.

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I have heard CPAs on more than one occasion recommend a client form a state law limited liability company, check the box to be taxed for federal income tax purposes as a corporation, and then make an S election.  The reason--according to the CPAs, less burdensome corporate paperwork--no need to keep minutes, bylaws, etc!  

I disagree that this is less complex.  

It is clearly possible for a state law limited liability company to elect to be taxed as a corporation and then make an S corporation election (if the entity otherwise qualifies to make such an election).  The question is--why?  I can imagine a few good reasons, but none of them include reducing the need for minutes or otherwise standard record keeping, or the burdens of needing bylaws.  

The somewhat decent arguments I can imagine for this contorted choice of entity are:

• The applicable state limited liability company statute is more favorable than the applicable state corporate statute.
• Perhaps, for example, because the state law on limiting the liability of the managers of the LLC is more favorable than the state law limiting the liability of directors and officers of the corporation.
• Or perhaps because the state law with respect to the governance of the LLC is more favorable than the state law with respect to the governance of the corporation.

In the author's opinion, whatever is to be gained in these regards is overshadowed by the complexity of the set up, and the confusion that it is likely to generate in future due diligence questions.  In most if not all cases the author believes that this choice of entity is likely to be more trouble than it is worth.

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I am frequently asked by founders of new businesses who want a pass through company for tax purposes whether they should organize their new company as an S corporation or a limited liability company.  It of course depends on the circumstances, but if the founders anticipate having a company which will grow rapidly, want to grant equity compensation to many new hires, and ultimately may either go public or be sold in an M&A transaction, I recommend an S corporation (assuming the entity qualifies to make an S corporation election), for the following reasons:

 1. S corporations can engage in tax free reorganizations, such as tax free stock swaps; in contrast, limited liability company owners have to pay tax on stock received in such transactions;

 2. S corporations can grant traditional types of employee equity, like stock options, more easily; and

 3. S corporations can more easily convert to C corporations in the event of a venture financing or public offering.

 That is not to say that a limited liability company may not be the right choice of entity in certain circumstances, but frequently S corporations are a better choice.

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