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

On Friday, the U.S. House of Representatives considered H.R. 5982, which would have, among other things, repealed the new Form 1099 rules.

Unfortunately, the House was unable to pass the repeal of the new Form 1099 rules. See here. A summary of H.R. 5982 with respect to the new Form 1099 rules is quoted below. It is unclear when this will be taken up again by either the House or the Senate.

Provide small business tax relief by repealing certain information reporting requirements to corporations and to payments of property. Starting in 2012, businesses will be required to file information returns with respect to any person (including corporations) that receives $600 or more from the business in exchange for property and merchandise. Furthermore, businesses will be required to file information returns with respect to corporations that receive $600 or more in exchange for services or other determinable gains. The bill would provide relief for small businesses by repealing these requirements before they take effect. This provision is estimated to cost $19.206 billion over 10 years.

Many groups have come out against the new Form 1099 rules, including the AICPA.

The new Form 1099 rules change the old rules by requiring reporting of amounts paid for property and to corporations, meaning that if you are in business and go to the Apple store and buy a new computer, you are going to have to issue Apple Computer a Form 1099. Similarly, if you regularly buy office supplies from Office Depot, and your purchases add up to over $600 over the course of the calendar year, you are going to have to issue Office Depot a Form 1099.

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Today (see floor schedule) the United States Senate will resume consideration of the Small Business Jobs and Credit Act of 2010.

The bill will exempt from capital gains tax gains on qualified small business stock acquired after March 15, 2010, and before January 1, 2012, and held for more than 5 years. The House has already passed this tax incentive.

This is what Senator Max Baucus had to say about this yesterday on the floor of the Senate.

In 1976, the United States economy was reeling from recession. America’s unemployment hovered around eight percent. That year, two guys named Steve started selling computer kits out of a garage in Palo Alto, California.

They founded a small business. An angel investor helped them with $250,000 in seed money. Today, we know that business as Apple. Last month, Apple became the largest technology company in the world.

....

According to a recent report, nearly all net job creation in America from 1980 to 2005 occurred in firms less than five years old. In fact, without start-ups, net job creation would have been negative almost every year for the past three decades.

In 2007, more than two-thirds of the jobs created were in firms between one and five years old.

As our economy emerges from the Great Recession, we need to ensure that American entrepreneurs have the resources, financing, and opportunities that they need to create jobs and realize their dreams.

This small business jobs bill would help American entrepreneurs access the capital that they need by increasing the incentives for investors to purchase and hold equity in start-ups.

Under this bill, for the rest of 2010, any investor who invested in a small business and held that investment for at least five years would pay no income tax on the gains from the sale of that small business stock.

It is a great idea, and one that will certainly be a boost for startup company investment. We need more angel investments like the one the Senator referred to.

It is unfortunate that the tax incentive is only for a limited time period, but perhaps it will be extended and ultimately made permanent.

Recently, Brad Burnham at Union Square Ventures wrote:

We have commented a number of times in a number of ways on this blog about how technology startups can no longer afford to ignore politics. ...Everything is suddenly impacted by public policy and we no longer have a choice about engaging in the process.

I agree with Brad. The startup community needs to be more vocal politically.

The tax bill is a good example. On the one hand we are trying to make entrepreneurship easier but on the other hand we have already made the lives of startups more difficult and are doing nothing about it.

For example, the Dodd-Frank bill's legislative language reduces the number of people who qualify as accredited investors (reducing the number who can act as angels to invest in startups and accordingly reducing the capital available to startups), and on the other hand we are about to offer a tax incentive to invest in startups. This is a conflicting set of policies that at some level doesn't make sense.

Another example, Senator Baucus speaks wisely about startups needing capital, yet we have bad laws which require startups to spend money on foolish things that don't create value--like 409A valuations, or the new healthcare bill's 1099 requirement. We need a global, coherent legislative strategy to make the lives of startups easier and better.

I like the temporary tax incentive the Senate is considering, but it would be nice if the small business bill did other things to make the lives of startups easier rather than just pass a temporary tax incentive. 

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One issue that is worth paying attention to in minority investment financing transactions in which an S corporation's S corporation status terminates is how losses in the year in which the S corporation status terminates will be allocated.

Investors might think that upon their investment and termination of the S corporation status, the losses funded with their dollars in the year of investment will generate a net operating loss in that year, and that those losses will be available to offset taxable income in future years. This is not necessarily true because of the way in which the losses allocated to the short S corporation tax year and short C corporation tax year will be calculated. If the investors acquire a minority stake, and if the S corporation status terminates on a date other than the first day of the corporation’s taxable year, the corporation's taxable year will be bifurcated into a short S year and a short C year, and it will be necessary to allocate the income and loss recognized by the corporation in the S termination year between these two short tax years.

Default; Pro Rata Allocation Method   

The default method applied to allocate the income or loss recognized by a corporation in an S termination year is the pro rata allocation method. Under this method, first the income or loss for the entire year is determined (for both the short S corporation part of the year and the short C corporation part of the year) and then an equal portion of such amount is assigned to each day of the S termination year (to both the S and C corporation short years). Because this default allocation method disregards the actual time at which items of income or loss are recognized, it can have unexpected results.

For example, suppose an institutional investor or other non-eligible S corporation shareholder invests $2M in an S corporation startup (with two existing shareholders who are both individuals, A and B) on July 1, and it is expected that the $2M will be substantially utilized before the end of the calendar year to fund operations of the startup.  On the investment the startup’s S corporation status will terminate because S corporations cannot generally have non-individual shareholders.  Assuming the startup uses a calendar year, the corporation's taxable year will be bifurcated into a short S year (running form January 1 though June 30) and a short C year (running from July 1 through December 31).    

You might think that the $2M expended from July 1 to December 31 would be allocated to the short C year in which it was realized, generating a net operating loss of approximately $2M--assuming the startup has no revenue.  However, under the default allocation method, half of the $2M loss is allocated to the short S year and passed through to A and B who may not be able to fully utilize this loss due to the limitations on the deductible of loss that apply to individuals.

Election To Have Items Assigned To Each Short Taxable Year Under Normal Tax Accounting Rules

The startup can elect out of the default allocation method – and follow a "closing of the books" method (which the Internal Revenue Code refers to as "Normal Accounting Rules") which allows the startup to close its books on the date its status as an S corporation terminates – but only if all shareholders consent.  In the above example, if all of the shareholders consent to a closing of the books election, the $2M net operating loss generated by the corporation in the C short year would be allocated to the C short year and carried forward to future table years and used to offset taxable income recognized in those future taxable years.  

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In the 2010 legislative session, the Washington State legislature enacted a number of new taxes. One of them was a Carbonated Beverage Tax. This tax is imposed on the sale of carbonated beverages at wholesale or retail in this state. The tax does not apply to successive sales of previously taxed beverages. The tax rate is $0.02 per 12 ounces of carbonated beverages. The tax went into effect on July 1st of this year and will expire on June 30, 2013.

If you have questions about the tax, you can call me. You may also find answers to your questions at one of the sites listed below.

There is a $10 million exemption from the tax for "bottlers." But bottlers do not include persons who contract with processors for hire for the bottling activity; bottlers are persons who actually bottle, can, or otherwise package carbonated beverages in contains.

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A bill has been introduced to eliminate the new Form 1099 filing requirements that were part of the healthcare reform bill.

For a press release announcing the new bill, see here.

Under the new Form 1099 rules, which will become effective in 2012, people in business will have to issue Forms 1099 to other businesses they pay more than $600 for goods during the year. This is a dramatic departure from prior law, which did not require the issuance of 1099s to corporations for goods.

As summarized by the IRS:

"For example, if a self-employed individual makes numerous small purchases from an office supply store during a calendar year that total at least $600, the individual must issue a Form 1099 to the vendor and the IRS showing the exact amount of total purchases."

In the press release announcing this bill, the new Form 1099 requirement was summarized this way:

"The provision forces all businesses, charities, and state and local governments to file 1099 forms if they purchase $600 or more in goods from another business throughout the year. This includes everything from supplies and shipping costs to phone and internet services."

So, solepreneurs, for example, will have to issue 1099 forms to office supply stores if over the course of the year they purchase more than $600 from any one office supply store, or if any one purchase exceeds $600.

It is unclear what the likelihood of passage is.

For coverage from The Hill, see here.

 

 

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Unless Congress changes the law, starting in the year 2012, businesses are going to have to issue Forms 1099 not only to individual independent contractors they pay more than $600 for services, but also to any individuals or corporations they pay more than $600 for services or goods. This is a radical change in the law, and one that will impose a very significant paperwork burden on people in business.

As summarized by the IRS:

"For example, if a self-employed individual makes numerous small purchases from an office supply store during a calendar year that total at least $600, the individual must issue a Form 1099 to the vendor and the IRS showing the exact amount of total purchases."

This means that if you are in business (say, as a solopreneur) and buy a new computer from Apple that costs more than $600, you will have to issue Apple a Form 1099, or if you regularly buy office supplies from Office Depot that total to more than $600, you will have to issue Office Depot a Form 1099.

If you are in business, you are going to have to keep track of all purchases you make by vendor so that you can comply with the new law or face tax penalties for failure to comply.

The new provision will apply to businesses of all sizes. There is no exception for small business or startup businesses.

The IRS acknowledges "[t]he ... new reporting requirement contained in the Patient Protection and Affordable Care Act may impose significant compliance burdens on businesses, charities, and government agencies." 

As summarized in more detail by the IRS:

Beginning in 2012, all businesses, tax-exempt organizations, and federal, state and local government entities will be required to issue Forms 1099 to vendors from whom they purchase goods totaling $600 or more during a calendar year.  To meet this requirement, these businesses and entities will have to keep track of all purchases they make by vendor.  For example, if a self-employed individual makes numerous small purchases from an office supply store during a calendar year that total at least $600, the individual must issue a Form 1099 to the vendor and the IRS showing the exact amount of total purchases.

As reported by the National Taxpayer Advocate:

Old Law	New Law
Information reporting was required for the purchase of services but was not required for the purchase of goods; prior law generally did not require a person to report payments to purchase goods presumably because the purchaser could not determine the amount that (less cost of goods sold) would have been income to the vendor.	Persons making payments in the course of a trade or business will soon be required to issue information reports to sellers of goods as well as providers of services.
Under a longstanding regulatory regime, moreover, there was an exception for payments to corporations as well as to tax-exempt and government entities.	Businesses will also will have to report payments to a corporations.

This is going to result in a substantial increase in the paperwork burden for businesses. The National Taxpayer Advocate has issued a report which identifies a number of problems, including:

1. First, vendors will have to furnish, and businesses will have to collect, TINs.
2. If a vendor fails to furnish a correct TIN, the business is required by law to impose back-up withholding at the rate of 28 percent of the purchase price.
3. Businesses will now have to keep records of all purchases sorted by TIN. Under the new law, the business will have to segregate its records by vendor TIN to determine whether the $600 annual threshold is met for each vendor.
4. If a business makes qualifying purchases from at least 250 vendors during the calendar year, it will be required to file Forms 1099 electronically.
5. Penalties may be imposed for failure to comply.
6. Small business may be put at a competitive disadvantage to larger companies with systems already in place to handle this burden.

Obviously, we have reached a point of absurdity in our tax law. Hopefully, Congress will change this law before it becomes effective.

For other good resources on this issue, see:

• CNNMoney
• NFIB
• The Hill
• Cato
• SMC Business Councils press release

Continue Reading...

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If you are interested in knowing what Congress is up to with respect to allowing states to require out-of-state internet retailers to collect and remit sales tax, the latest bill making the rounds, the "Main Street Fairness Act" (the "Act"), is attached. You can find a summary of the bill here.

The highlights of the proposed Act are:

• Once ten states, comprising at least 20% of the total population of all states imposing a sales tax, have become Member States under the Streamlined Sales and Use Tax Agreement (the "SSUTA"), the states that implement the SSUTA are authorized to require remote sellers to collect and remit sales and use taxes (with or without physical presence or the Quill standard having been met). A state's authorization terminates if the state falls out of compliance with the SSUTA, or the SSUTA as amended no longer meets the minimum simplification requirements in the Act.
• The minimum simplification requirements include, among other things: a centralized, one-stop, multistate registration system that a seller may elect to use to register with the Member States.
• Nothing in the Act is to be construed as subjecting sellers to franchise taxes, income taxes, or licensing requirements of a state or political subdivision of a state.
• No obligation imposed by the authority granted under the Act is to be considered in determining whether a seller has nexus with any state for any other tax purpose.

It is unclear how much traction this bill may garner. Prior attempts to change the federal law to allow states to collect and remit sales tax from out-of-state retailers with no physical presence in a state have failed. However, with state and local governments under threat of significant budget deficiencies, and a Congress apparently unwilling to fund more without offsetting tax increases or other budget cuts, a bill like this may become law.

What would this mean for startup Internet retailers with no physical presence except in their home state? At least with respect to Member States they would be required to collect and remit sales tax in those states even if they had no physical presence there. As you will see from reading the bill, its provisions are complex and more difficult to understand than the simple physical presence rule from Quill. Would this be unfortunate for startups? I believe so. More complexity makes life more difficult for startup companies, and businesses in general.

The Hill's On the Money Blog is carrying continuing coverage of the politics around this bill.

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As I've previously blogged, the U.S. House of Representatives approved a complete elimination of capital gains taxes on qualified small business stock purchased between March 15, 2010 and January 1, 2012, including a repeal of the alternative minimum tax associated with the IRC Section 1202 tax benefit.

Now the Senate is going to consider the same bill, as part of its small business lending bill, when it returns from the July 4th recess.

You can find links to the statute and the explanation of the statute here.

A summary of the QSB exclusion states as follows:

100% Exclusion of Small Business Capital Gains. Generally, non-corporate taxpayers may exclude 50 percent of the gain from the sale of certain small business stock acquired at original issue and held for more than five years. For stock acquired after February 17, 2009 and before January 1, 2011, the exclusion is increased to 75 percent. At the time of sale, however, 28% of the excluded gain will be treated as a tax preference item subject to the alternative minimum tax (AMT). Qualifying small business stock is from a C corporation whose gross assets do not exceed $50 million (including the proceeds received from the issuance of the stock) and who meets a specific active business requirement. The amount of gain eligible for the exclusion is limited to the greater of ten times the taxpayer’s basis in the stock or $10 million of gain from stock in that corporation. This bill would temporarily increase further the amount of the exclusion to 100 percent of the gain from the sale of qualifying small business stock that is acquired after the date of enactment in 2010 and held for more than five years. Additionally, the bill eliminates the AMT preference item attributable for that sale. This provision is estimated to cost $517 million over ten years.

If the Senate passes this bill, hopefully it will work a little like the home purchasing tax credit, and cause some sort of "surge" in investments in startups. Is it unfortunate that the provision isn't permanent? I think so. However, I believe it is a step in the right direction. Investments in startups translate directly into jobs.

 

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I recently received an email from a friend asking for a status report on a couple of the securities and tax law issues that I have been twittering about as they've flowed through the political system. Below is a "political action scorecard" on the issues I've been following.

 

Issue	Status
Carried Interest Tax Hike Proposal	This proposal was in the tax extenders bill the Senate couldn't pass after three tries; it is unclear whether this will be included in another bill.
Temporary Repeal of Capital Gains on QSB Stock	This proposal was passed by the House; I am not sure when it may be taken up by the Senate. It may become part of the small business bill to be taken up by the Senate next week.
New S corporation taxes	This proposal was in the tax extenders bill the Senate couldn't pass; it is unclear whether this will be included in another bill.
Exclusion of primary residence from "accredited investor" definition	I believe this was in the conference committee agreed upon financial regulatory reform bill, but we haven't seen the actual language yet to confirm.

 

If you have any news to share on the status of these various proposals, please share so that I can update the scorecard.

 

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As I blogged last week, Congress is considering taking away the employment tax benefits of being an S corporation for certain small professional services businesses.

The first bill that was proposed targeted S corporations engaged in professional service businesses if the principal asset of such businesses was the reputation and skill of 3 or fewer employees. This bill gave rise to some hue and cry over what these concepts meant. The charge was that these provisions were too vague to be readily interpretable.

Senator Baucus has now proposed that this language be changed to target S corporations engaged in professional services businesses if 80 percent or more of the gross income of such businesses is attributable to the service of 3 or fewer shareholders. So, Senator Baucus's amendment removes the concepts of "principal asset," "reputation and skill," of "employees," and substitutes for those concepts "80 percent or more of the gross income" "attributable" to "3 or fewer shareholders."

 A redline of all of the initial proposal against the new proposal is here.

Old Concepts	New Concepts
principal asset	80% or more of gross income
reputation and skill	attributable
3 or fewer employees	3 or fewer shareholders

The Senate Finance Committee described the changes this way:

Changes to Employment Taxes on Earning of Certain Service Professionals.  Social Security taxes are imposed on compensation and self-employment income up to the Social Security Wage Base (currently $106,800) and the Medicare tax is imposed on all self-employment and compensation income. Some service professionals have been avoiding Medicare and Social Security taxes by routing their self-employment income through an S corporation. These taxpayers then pay themselves a nominal salary and take the position that the remaining earnings are exempt from employment taxes. A provision passed by the House and included in the original Baucus substitute would address this abuse in situations where (1) an S corporation is a partner in a professional service business or (2) an S corporation is engaged in a professional service business that is principally based on the reputation and skill of 3 or fewer individuals.   This provision does not change the ability of S corporations to use some income to make business investments or deduct those small business investments.  To make the second alternative more administrable and more targeted, this amendment changes the language so that the policy applies only if 80 percent or more of the professional service income of the corporation is attributable to the services of 3 or fewer owners of the corporation.  This proposal, as amended, is estimated to raise $9.15 billion over 10 years.  

These are welcome changes from a clarity point of view, but these tax provisions are still problematic because they are targeting the smallest companies in America. Why are S corporations 80% or more the gross income of which is attributable to the services of 3 or fewer shareholders being targeted for increased taxes? Why not broad-based employment tax law changes? Evidently the desire and/or need for revenue trumps treating small businesses the same as larger businesses.

These opinions are my own.

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Today the House passed a bill which would completely exempt from capital gains taxes (subject to per taxpayer limitations) the gain on the sale of qualified small business stock held for more than 5 years, if such stock was purchased after March 15, 2010, and before January 1, 2012. It is unclear if the Senate will pass this bill. The bill also makes clear that no part of the exclusion is an alternative minimum tax adjustment. The provision as passed by the House is quoted below.

For press coverage, see The Hills' coverage.

If the Senate passes this provision, a lot more intensity will be brought to bear on representations and warranties in stock purchase agreements that stock being purchased qualifies as "qualified small business stock." In addition, special scrutiny will be brought to bear on redemptions and other historical transactions which could disqualify stock from qualifying.

As I've indicated before, I think that the short window in which this 100% exclusion is actually available makes it sort of a gimmick. It seems to me that only individual investors who would otherwise have been likely to invest in qualifying companies during this window already will be the ultimate beneficiaries of this provision. So, think of it like a bailout in a sense for taxpayers in that spot. If Congress really wanted to shift behavior, it would enact permanent tax reductions of some kind related to investments--not short term gimmicks and ploys. Still, for qualifying investors, it is hard to complain.

In general, "qualified small business stock" is stock in a C corporation acquired by a taxpayer at its original issue if as of the date of issuance such corporation was a "qualified small business," and during substantially all of the taxpayer's holding period for such stock, the corporation met certain active business requirements and was a C corporation. A "qualified small business" in general means a business with less than $50 million in gross assets. The active business requirements require that at least 80 percent (by value) of the assets of the corporation be used by the corporation in the active conduct of 1 or more "qualified trades or businesses."

“Qualified trade or business” means trade or business other than:

• trades or businesses involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees;
• any banking, insurance, financing, leasing, investing or similar business;
• any farming business (including the business of raising or harvesting trees);
• any business involving the production or extraction of products of a character with respect to a which a deduction is allowable under Section 613 or 613A;and
• any business of operating a hotel, motel, restaurant or similar business.

The provision as passed:

SEC. 501. TEMPORARY EXCLUSION OF 100 PERCENT OF GAIN ON CERTAIN SMALL BUSINESS STOCK.

(a) In General- Subsection (a) of section 1202 is amended by adding at the end the following new paragraph:

`(4) SPECIAL 100 PERCENT EXCLUSION- In the case of qualified small business stock acquired after March 15, 2010, and before January 1, 2012--

`(A) paragraph (1) shall be applied by substituting `100 percent' for `50 percent',

`(B) paragraph (2) shall not apply, and

`(C) paragraph (7) of section 57(a) shall not apply.'.

(b) Conforming Amendments- Paragraph (3) of section 1202(a) is amended--

(1) by striking `after the date of the enactment of this paragraph and before January 1, 2011' and inserting `after February 17, 2009, and before March 16, 2010'; and

(2) by striking `SPECIAL RULES FOR 2009 AND 2010' in the heading and inserting `SPECIAL 75 PERCENT EXCLUSION'.

(c) Effective Date- The amendments made by this section shall apply to stock acquired after March 15, 2010.

 

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As reported in the Wall Street Journal, the House may consider as early as Thursday a bill that would temporarily eliminate capital gains taxes on qualified small business stock held for more than 5 years, in an attempt to drive investment capital toward small businesses that qualify as qualified small businesses under Section 1202 of the Internal Revenue Code. 

The bill would only open the window for the 100% exclusion for qualifying investments made between March 15, 2010 and before January 1, 2012. It seems unlikely, given the length of time it takes for startup companies to raise money, and for investors to make investment decisions in startups, that a window of opportunity this short will do anything other than bestow the benefit on parties who would already have been likely to make investments in startup companies during this period.

My suggestions to improve the bill:

• Congress should consider the securities law aspects associated with investments in startups. For the most part, this tax benefit is only going to be available to "accredited investors," the same group Congress wants to tax more heavily in other instances. Congress ought to make the securities law exemptions broader and more available to a greater group of people. For example, everyone (although this would run contrary to the Dodd bill, which would narrow the group of people who qualify as "accredited investors").
• If Congress's desire is to drive capital into businesses that it perceives are creating jobs, it ought to make this tax exclusion permanent.
• If Congress really wants to drive capital into businesses that it perceives are creating jobs, why not, instead of a capital gains exclusion available after 5 years, allow investments in these companies to be deducted in the year in which the investment is made? (Right now, investors who buy stock can't recover the basis in their investment until they sell their stock; if you buy equipment, you can deduct that either all at once or over a fairly short period of time. In other words, the tax code heavily favors investments in equipment over investments in stock.)
• Or even better, give investors a dollar-for-dollar tax credit for their investments?
• Or even better, give investors a dollar-for-dollar tax credit for money paid to employ people in any job?

What would Secretary Newco say? What would Glenn Kelman say? I think I know what @cdixon would say. What would Michael Arrington say?

The exclusion is summarized by the Ways and Means Committee as follows:

100% Exclusion of small business capital gains. Under current law, Section 1202 provides a fifty-percent (50%) exclusion for gain from the sale of certain small business stock that is held for more than five years. The amount of gain eligible for the Section 1202 exclusion is limited to the greater of 10 times the taxpayer’s basis in the stock, or $10 million gain from stock in that small business corporation. This provision is limited to individual investments and not the investments of a corporation. The non-excluded portion of section 1202 gain is taxed at the lesser of ordinary income rates or 28 percent, instead of the lower capital gains rates for individuals. The American Reinvestment and Recovery Act (the “Recovery Act”) temporarily increased the Section 1202 exclusion to seventy-five percent (75%) for qualifying stock acquired in 2009 and 2010. The bill would temporarily increase the amount of the exclusion to one hundred percent (100%) for qualifying stock acquired after March 15, 2010 and before January 1, 2012. This provision is estimated to cost $1.962 billion over 10 years.

More information on this bill is available at the Ways and Means Committee web site.

The opinions expressed here are my own.

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The Senate has released its version of the tax extenders bill, and a summary. It has changed the taxation of the carried interest as approved by the House. The change is summarized below. Links to the summary of the bill and bill are also below. There appears to have been no change made to the onerous S corporation tax provisions.

Summary of the bill.

Full text of bill.

You can also find links to both at this site.

From the summary regarding the taxation of carried interest:

Taxation of Carried Interest. This modification decreases the amount of carried interest that is recharacterized as ordinary income from 75 percent to 65 percent and increases the amount treated as capital gains from 25 percent to 35 percent in taxable years beginning after December 12, 2012. The change further decreases the amount of carried interest that is recharacterized as ordinary income to 55 percent and increases the amount treated as capital gains to 45 percent for gain or loss attributable to the sale of an asset which is held for 7 or more years. Another modification provides that a non-service individual or widely held regulated investment company who sells an interest (held directly or indirectly through a partnership, S corporation, estate, trust) in an energy-related publicly traded partnership is exempt from recharacterization as ordinary income under Internal Revenue Code section 751(a) that portion of the gain or loss attributable to investment services partnership interests held by the publicly traded partnership. With these modifications, this provision is estimated to raise $14.453 billion over 10 years.

 

 

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05.18.10

By Nigel P. Avilez and Michael J. Killeen

 In 2009, Washington state’s Employment Security Department (ESD) paid out nearly $4 billion in unemployment benefits, setting a state record for unemployment claims. This compares to $1.2 billion in 2008 and $725 million in 2007.¹ With the increased demands for benefits, Washington, like other cash-strapped states and the federal government,² is trying to increase payroll tax collections by aggressively challenging independent contractor classifications, tax rates and reporting.

Continue Reading...

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Dear technology executive,

Take Action - Your Voice Needed to Oppose New Software Tax System

Please contact your state Senator today and tell them to reject the new custom software tax included in the House Version of Senate Bill 6143! 

In the past 24 hours, the state House of Representatives has passed a bill that will create a new tax on a whole range of innovative software companies that are at the center of our technology industry. Without any input from industry, the House passed a version of Senate Bill 6143 that includes a new tax on custom software development-a fundamental shift in tax policy that could lead to job losses, business closures and new taxes on other professional services.

There are over 2,500 custom software businesses in our state and most of these are small companies-and many are independent and freelance consultants. These companies and their employees already pay over $150 million in state and local taxes and are held up as the kind of innovation businesses we want to encourage in Washington.

Yet this new tax scheme does just the opposite of encourage.

The challenge before the Governor and our Legislators is not an easy one, but this new tax is not the answer. If you agree with us, then please contact your state Senator today and tell them to reject the new custom software tax included in the House Version of Senate Bill 6143.

We have already drafted a message for you to send, please click on the take action now link below to be redirected to our grass roots government affairs mobilization tool.  Thank you.

TAKE ACTION NOW

If you have any questions or concerns, please contact Lew McMurran, our Vice President of Government & External Affairs at Lmcmurran@washingtontechnology.org.  Want to learn more about this topic?  Visit Lew's Government Affairs Blog.

Sincerely,


Ken Myer
President & CEO
Washington Technology Industry Association (WTIA

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By Pamela M. Charles and Craig Gannett
03.11.10

In a major smart grid development, the Internal Revenue Service yesterday released guidance (Rev. Proc. 2010-20) providing a safe harbor under which the $3.4 billion in Smart Grid Investment Grants (SGIGs) made pursuant to the American Recovery and Reinvestment Act (ARRA) will not be taxable to corporate recipients. After months of uncertainty, this determination will allow corporate recipients to finalize their grant agreements with the Department of Energy (DOE) and launch their investments without concern that they will be subject to federal taxation.

This guidance provides that the IRS will not challenge a corporation’s treatment of an SGIG as a nonshareholder contribution to the capital of the corporation so long as the corporation properly reduces the tax basis of the property it acquires with the grant (or other property owned by the corporation). Nonshareholder contributions to capital are not included in a corporation’s gross income for federal income tax purposes. This guidance is effective immediately and will allow DOE to begin finalizing grant agreements with the various utilities, private companies, manufacturers and others who have been authorized to receive these grants.

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Check out this informative presentation by DWT partner Jim Wreggelsworth on carried interest: STORM CLOUDS ON THE HORIZON: AN UNCERTAIN FUTURE FOR TAXATION OF CARRIED INTERESTS (PPP).

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We've written about this before. The President has proposed to reduce the capital gains tax rate on qualified small business stock to zero.

He said it again last night in his State of the Union speech.

You can view the video below. The President's comment is at minute 6:50. He says:

"While we're at it, let's also eliminate all capital gains taxes on small business investment."

Reducing the capital gains tax rate to zero on qualified small business stock would be extremely beneficial to businesses that qualify for the QSB tax benefit, and would probably create a flood of investment in that direction.

Also see this article on pehub.

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Please provide comments on this preliminary draft bill.

 

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by Garry Fujita

In an effort to expand the tax base, the legislature may consider legislatively enacting an economic nexus standard for taxpayers that sell services and other similar intangibles.  There is no bill formally introduced in the legislature at this time.  The preliminary bill draft contemplates using three factors to determine if economic nexus exists:

>25% of a taxpayer's total property or $50,000 of property is in the state, or

>25% of a taxpayer's total payroll or $50,000 of payroll is in the state, or

>25% of a taxpayer's total receipts or $500,000 of receipts is from this state.

The state understands that the U.S. Supreme Court has not expressly ruled on whether economic nexus can be applied in light of Quill, but the state believes that 30 states have used an economic nexus standard.   The state feels that the U.S. Supreme Court has declined several petitions to review the issue, and that fact signals that the high court accepts the notion that economic nexus can exist outside the Quill fact pattern.  The state understands that it may be taking a risk that the Court will strike down economic nexus or that Congress might legislate permissible nexus upon which a state's taxing authority attached, so the bill contains language that the state believes will put the taxpayers back to the status quo in that event.

There are other important and unattractive aspects to this approach.  First, if this was enacted, then the state would be constitutionally required to apply the same standards to instate companies engaged in interstate commerce.  The statute would apply a single factor sales apportion formula (making rules like WAC 458-20-194 and 458-20-14601 dispensable), which means that it is really an allocation of income to only one state.  This is good news for instate businesses that sell services in interstate commerce and have been reporting income on an apportioned basis. Under this new approach, for instate businesses, this would likely mean that their income will be allocated to the buyer's out of state locations, resulting in tax on 0% of its out-of-state sales.  For out-of-state businesses, this would likely mean that their income will be allocated to the buyer's instate location, resulting in tax on !00% of its Washington sales.  Second, this allocation theory (described as apportionment) raises concerns as to whether this is really an unapportioned gross receipts tax on services and royalties and whether it is constitutional.  This method effectively transfers the tax burden from the instate businesses selling out of state to the out-of-state taxpayers selling into Washington.

 

 

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Another bill being considered now in Olympia is Senate Bill 6723. It is not a long bill. In full, it says:

"Sec. 1. (1) The legislature finds that the administration of the property tax on personal property is inefficient for government and business. The legislature concludes that a study is necessary to identify methods to best accomplish the elimination of the personal property tax.

 (2) The department of revenue must conduct a study on alternatives for eliminating the property tax on personal property. In conducting the study, the department must examine the cost of administering the tax, savings to government and taxpayers by eliminating the tax, the effect on property tax rates, and property tax shifts.

 (3) The department of revenue must seek the advice and input of local officials administering the property tax.

 (4) The department of revenue must present a final report of its findings and alternatives, including a legislative draft proposal, to the ways and means committee in the senate and the finance committee in the house of representatives by October 31, 2011."

It would certainly be good for tax simplicity to do away with this tax. In my experience, many entrepreneurs are surprised there is such a thing as the personal property tax. Granted, as you learn in law school, ignorance of the law is no excuse, but that aphorism made a lot more sense when the laws we lived under were not so voluminous.

The views expressed here are my own.

 

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One of the many tax bills being considered in Olympia right now is House Bill 2972. One of the aims of HB 2972 (see Part III) is to make clear that director fees are taxable for business and occupation tax purposes in Washington State.

HB 2972 states as follows:

"(3) The legislature finds that corporate directors are not employees or servants of the corporation whose board they serve on and therefore are not entitled to a business and occupation tax exemption under RCW 82.04.360. The legislature further finds that there are no business and occupation tax exemptions for compensation received for serving as a member of a corporation's board of directors.

(4) The legislature also finds that there is a widespread misunderstanding among corporate directors that the business and occupation tax does not apply to the compensation they receive for serving as a director of a corporation. It is the legislature's expectation that the department of revenue will take appropriate measures to ensure that corporate directors understand and comply with their business and occupation tax obligations with respect to their director compensation. However, because of the widespread misunderstanding by corporate directors of their liability for business and occupation tax on director compensation, the legislature finds that it is appropriate in this unique situation to provide limited relief against the retroactive assessment of business and occupation taxes on corporate director compensation.

(5) The legislature also reaffirms its intent that all income of all independent contractors is subject to business and occupation tax unless specifically exempt under the Constitution or laws of this state or the United States. 

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A bill has been introduced in Olympia to codify economic substance as the prevailing theory in reviewing potentially abusive tax avoidance transactions.  This bill would substantially change Washington tax law.

Under the proposed bill, the Department of Revenue "must disregard, for tax purposes, abusive tax avoidance transactions."

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By Michael Gentile

The Internal Revenue Code contains a number of preferential tax treatment provisions for small businesses. One that is often overlooked is Section 1045, which generally permits a non-corporate taxpayer to elect to defer recognizing gain on the sale of qualified small business (QSB) stock held for more than six months to the extent the proceeds are reinvested in other QSB stock during a 60-day period beginning on the date of the sale.  

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I am frequently asked the following question:  Can a service provider receive a warrant in connection with the provision of services?

The short answer is yes, but it is important to keep in mind that a warrant received in connection with the performance of services will be taxed just like a compensatory stock option. 

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The US House of Representatives today voted to subject the carried interest to tax as ordinary income and employment taxes.  

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By Michele Radosevich

In the 2009 session, the Washington Legislature mandated big changes in the way that goods and services are taxed if those goods and services are delivered digitally. Under the new law, the notion that the sales and use tax primarily applies to tangible personal property is only a memory. On July 26, 2009, many sellers of internet-based products had to begin collecting sales tax from their customers. However, there is benefit. At the same time, some of these sellers’ business & occupation tax rate was cut by two-thirds, and their basis for apportioning income changed dramatically.

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Upcoming Finance SIG

Digital Goods & Year End Tax Planning -- How do the Changes Affect You? October Finance SIG Davis Wright Tremaine LLP, Davis Center 10/29/09 | 5:30pm to 7:30pm Do you sell games downloaded onto mobile phones? Do you offer a web service for a fee? Do your customers access your software from remote locations? If you answered yes to any of these questions, you are now required to collect sales tax from your customers in Washington state under the new digital goods tax. Washington is one of the first states to impose sales tax on a wide range of digital products that are purchased by both consumers and businesses. For sellers of digital products, you just got a B&O tax reduction but you have to now collect sales tax from your Washington based customers and remit it to the state. If you are a buyer of digital goods, you may now have new sales and use tax obligations that you didn’t have before. Hear from a panel of experts in this groundbreaking law about the various and complicated issues surrounding this new tax. Schedule: 5:30-6:30 | Registration, light appetizers & networking 6:30-7:30 | Panel discussion, Q&A Please join us for a very educational discussion and chance to talk to experts in the field!

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Startups frequently have to answer this question:  What type of equity incentives should they grant their employees?  For C corporations and S corporations there are generally 4 possibilities:

• nonqualified stock options (NQOs);
• incentive stock options (ISOs);
• restricted stock; and
• phantom equity.

ISOs are stock options that qualify for the special tax benefits under section 422 of the Internal Revenue Code (no ordinary income tax on exercise—but watch out for AMT (alternative minimum tax)—and capital gain on sale if 2 holding periods are met).  Among other restrictions, ISOs (a) can only be granted to employees, pursuant to a shareholder approved plan; (b) must have a term not greater than 10 years (or 5 in certain circumstances); (c) must have an exercise price not less than fair market value as of the grant date (or greater in certain circumstances); and (d) not more than $100,000 in value can vest in any 1 year.  By restricted stock, I mean actual stock issuances, subject to repurchase rights at cost (or similar restrictions), which restrictions lapse over a vesting period.  And by phantom equity I mean a wide range of contractual arrangements (such as stock appreciation rights) that are not actual shares of stock, but are designed to approximate the rewards of stock ownership.

The type of equity award a company should grant its employees depends in part on the stage of the company.  For very early stage companies the tax consequences of restricted stock can be favorable (employee starts capital gains holding period) and bearable (meaning the tax owed upon grant, if there are no repurchase restrictions, or in connection with filing an election under Section 83(b), if there are restrictions, is not too painful).  However, once a company's value has gone up, such that issuing inexpensive stock from a tax standpoint is too expensive or too uncomfortable, I usually recommend companies use NQOs for the following reasons:

• The potential benefits of ISOs (no tax on exercise (as opposed to ordinary income on the exercise of an NQO), and nothing but capital gain on sale) are rarely in fact realized.  Usually the holding periods to obtain these benefits aren't met, and the employee then has ordinary income when the stock is sold in a liquidity event;
• The AMT consequences to an employee upon an ISO exercise are frequently more significant than expected (and being surprised that you owe more in tax than you expected is never good);
• The company gets a tax deduction on the exercise of an NQO;
• NQOs are less complex (you don't have to worry about AMT adjustments, the consequences of not meeting holding period requirements, etc.);
• NQOs are more transparent from a tax reporting perspective because you calculate and have to make estimated tax payments up front at exercise (which reduces the likelihood of a surprise at tax return filing time);
• Restricted stock is not as favorable because employees lose control over the timing of the incidence of the tax (if no Section 83(b) election is made at grant, restricted stock is taxable upon vesting (when the value may be significantly greater than at grant, meaning much more tax is owed than might have been initially expected), as opposed to an option which is taxable when the employee decides to exercise). Having some control over the timing of the incidence of the tax is important; and
• Phantom stock or similar arrangements tend to be complicated and employees view them as inferior to actual stock options.

The table below summarizes some of the key federal income tax consequences of each of these types of awards. It is a high level summary only.  If you want more detail, please contact me.

Tax Consequences	NQO Priced at FMV at Grant	ISO Price at FMV at Grant	Stock Grant
At Grant	None (as long as priced at FMV)	None (as long as priced at FMV)	Taxable unless subject to vesting restrictions, or even if subject to vesting restrictions, taxable if the recipient elects to be taxed immediately by filing an 83(b) election within 30 days of receipt
At Vesting	None (as long as priced at FMV)	None (as long as priced at FMV)	Taxable if not already taxed; tax based on FMV of shares on vesting (income and employment taxes due at this time for employees)
Upon Exercise	Taxed as ordinary income (income and employment taxes due at this time)	No ordinary tax; AMT adjustment (watch out, can be very significant)	Not applicable
Upon Sale	Capital gain (short term or long term depending on time passed since exercise)	Capital gain if holding periods are met (2 years from grant; 1 year from exercise); otherwise, ordinary income)	Capital gain (short term or long term depending on time passed since the value of the shares was taken into income)

 

 

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The Obama Administration is continuing (see prior blog entry re this) to propose that venture capital firms be required to register with the SEC.  In general, under current law, most venture capital firms are not required to register with the SEC as investment advisors.  Requiring registration would impose additional costs and burdens on the venture capital industry, and would probably crimp industry participation to some degree, and slow down the flow of capital to and through funds to startup companies.

The Obama Administration also wants to subject venture capital funds "carried interest" to tax at ordinary income tax rates and self-employment taxes.  For information on this, see here.

The below quoted material is from the Obama Administration's Financial Regulatory Reform proposal.  See also this article from the Wall Street Journal.  See also this article.  Also see this bill introduced which would set the threshold for mandatory SEC registration of venture funds at $30 million.  Finally, see John Cook's article here.

The below quoted text is from Obama's financial regulatory overhaul proposal:

"F. Require Hedge Funds and Other Private Pools of Capital to Register

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act. The advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

In recent years, the United States has seen explosive growth in a variety of privately owned investment funds, including hedge funds, private equity funds, and venture capital funds. Although some private investment funds that trade commodity derivatives must register with the CFTC, and many funds register voluntarily with the SEC, U.S. law generally does not require such funds to register with a federal financial regulator. At various points in the financial crisis, de-leveraging by hedge funds contributed to the strain on financial markets. Since these funds were not required to register with regulators, however, the government lacked reliable, comprehensive data with which to assess this sort of market activity. In addition to the need to gather information in order to assess potential systemic implications of the activity of hedge funds and other private
pools of capital, it has also become clear that there is a compelling investor protection rationale to fill the gaps in the regulation of investment advisors and the funds that they manage.

Requiring the SEC registration of investment advisers to hedge funds and other private pools of capital would allow data to be collected that would permit an informed assessment of how such funds are changing over time and whether any such funds have become so large, leveraged, or interconnected that they require regulation for financial stability purposes. 

We further propose that all investment funds advised by an SEC-registered investment adviser should be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements. The SEC should conduct regular, periodic examinations of such funds to monitor compliance with these requirements. Some of those requirements may vary across the different types of private pools. The regulatory reporting requirements for such funds should require reporting on a confidential basis of the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the Federal Reserve. The Federal Reserve should determine whether any of the funds or fund families meets the Tier 1 FHC criteria. If so, those funds should be supervised and regulated as Tier 1 FHCs."
 

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 Congress is moving into high gear on health care reform, and is looking for revenue raisers to fund it.  The carried interest tax on venture capital firms is on the table.

There is a good article in the New York Times written on Friday regarding this; see also this article in the Wall Street Journal.  Obama's budget includes revenue raised from taxing the carried interest as ordinary income in its projections.  At this point, it would appear that the likelihood of the carried interest avoiding being taxed as ordinary income is low.

For more information on the carried interest, see CarriedInterest.org.  We will keep you updated as we learn more.

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A: If you exercise your warrant by paying cash for the exercise price, your capital gains holding period does not start until you exercise your warrant.  (Unfortunately, there is some uncertainty as to whether the holding period starts on the day of the exercise of the warrant or the day after.  See here.) 

If you exercise your warrant in a cashless exercise, there is uncertainty as to the right answer.  Some taxpayers argue that the cashless exercise of a warrant is a recapitalization event itself entitling the taxpayer to tack their holding period back to the date of the acquisition of the warrant.  See the attached letter, in which the New York State Bar Association states:  "If a cashless exercise constitutes a recapitalization, the warrant holder's holding period for the stock received upon exercise would generally include the holding period for the warrants."  

 

 

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In what could be a serious blow to the venture fund industry, the President's tax proposals contemplate taxing carried interest as ordinary income, subject to ordinary income tax rates and self employment taxes.

The proposal states that it "is not intended to adversely impact qualification of a real estate investment trust owning a carried interest in a real estate partnership."

Excerpt from a summary of the President's proposal is below.  You can also find them on pages 25 and 26 of this document.

 

 

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In what could be a very welcome development in startup land, if it becomes law, President Obama has proposed that there be NO capital gain taxation of gains from the sale of qualified small business stock issued after February 17, 2009 and held for 5 years.  Presumably the limitations of IRC 1202 that cap the QSB benefit at the greater of (i) 10x a taxpayer's basis in stock issued by the corporation and disposed of during the year, or (ii) $10M reduced by gain excluded in prior years on dispositions of the corporation's stock would still apply.  However, this would still be quite a benefit.

See pages 13-14 of this document.  The entirety of pages 13 and 14 are also quoted below.

 

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It is fairly common in connection with a financing that an investor will require a founder to agree to place a certain number of the founder's fully vested and owned founders shares under an at-cost repurchase restriction, which at-cost repurchase right lapses over a new vesting period.  

The question that this raises from a federal income tax perspective is whether the founder should or needs to file a Section 83(b) election upon the imposition of the new vesting conditions.  The IRS answered this question in Revenue Ruling 2007-49.

"In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by A are subjected to a restriction causing them to be “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by A for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83."

 

 

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Early stage companies frequently want to bring on key hires and incentivize them with equity, but do not know what type of equity award is the best from a tax perspective to both the employee and the company.  There are in general two types of equity awards most commonly used (assuming that the company is operating in the corporate form and not as a limited liability company):

• stock options; and
• stock awards or stock grants.

In general, for a private company with limited cash reserves, and whose key hires also desire to preserve their cash (and not pay it to the IRS), stock options are usually going to be a preferable alternative to stock grants (unless the current value of the stock is so low that the immediate tax impact is nominal).  

The reason?  Stock grants will be taxable either (1) upon grant, if fully vested, or if a Section 83(b) election is made (in which case the taxes must be paid immediately upon grant, and will have to be withheld from the employee--i.e., the employee will have to write a check to the company for the taxes), or (2) upon vesting, when the value may be considerably higher than the value on the date of grant (and the taxes must then be paid at that time, and the employee will have to write a check to the company at that time for the taxes).  

The primary benefit of a stock option as opposed to a stock grant is that if the stock option is priced at fair market value on the date of grant, the receipt of the option is not taxable to the optionee, and the option will not be taxable at all until exercise--the timing of which the optionee controls (as opposed to a vesting date for a restricted stock award).

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As if the venture capital industry did not have enough to worry about, with the Treasury's proposal to require venture funds above a certain size (not yet specified) to register with the SEC, it also appears that the effort to tax their "carried interest" as ordinary income will remain in the mix.  Representative Sander Levin, of Michigan, re-introduced legislation last Friday that would tax the carried interest of venture capital funds as ordinary income.

Excerpts from his press release (which can be found on the House Ways and Means Committee web site) are below:

 “Washington, DC – Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working  Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.  

Click here to view the legislation."

More:

"Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase."

 

 

 

 

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 If you didn't pay alternative minimum tax on your incentive stock option exercises prior to January 1, 2008, and you owe the IRS a bunch of money--don't worry about it.

The Internal Revenue Code now provides that any "underpayment of tax outstanding on the date of the enactment of this subsection which is attributable to the application of section 56(b)(3) for any taxable year ending before January 1, 2008, and any interest or penalty with respect to such underpayment which is outstanding on such date of enactment, is hereby abated."

Section 56(b)(3) is the provision which provides that the gain on the exercise of incentive stock options is an alternative minimum tax adjustment.  So, the Code now says, quite literally, that if you owe taxes attributable to the exercise of incentive stock options for a tax year ending before January 1, 2008, and interest and penalties on such taxes, you don't have to worry about it!

Taxpayers should be aware that the provision is only effective for ISO exercises prior to January 1, 2008, and does not extend into the future.

For more information, see:

• Wall Street Journal Smart Money Article
• This blog entry

 

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Under Section 83(a) of the Internal Revenue Code, a taxpayer who receives property in connection with the performance of services must generally recognize as ordinary income the difference between the value of the property and the amount paid in exchange therefor at the first time the property is either transferable or not subject to a substantial risk of forfeiture. Section 83(b) allows a taxpayer who receives property in connection with the performance of services that is subject to such restrictions (e.g., nonvested property) to elect to recognize this income at the time of transfer.  The principal benefit of a Section 83(b) election is that the taxpayer can lock in appreciation which is generally taxable at capital gains rates upon later disposition.  

 

For example, suppose a startup company founder is issued founders' stock that is subject to a company repurchase at the stock's cost, but the repurchase right lapses over a service based lapsing period.  This founder has received stock, but because the stock is subject to a substantial risk of forfeiture (the at-cost repurchase right lapsing over the service based vesting period), the founder does not have to pay tax on his receipt of the stock until it vests.  However, the founder may prefer to make a Section 83(b) election to pay tax on the value of the stock today because its value is lower than it is expected to be when it vests--or because the founder paid full value for it today, so the Section 83(b) election costs him no additional tax today.  The making of the Section 83(b) election also starts the founder's capital gains holding period.

It is a common misconception, but a Section 83(b) election generally cannot be made with respect to the receipt of a private company stock option.  You must exercise the option first and acquire the stock before you can make a Section 83(b) election, and you would only make a Section 83(b) election in that instance if you exercised the option and acquired unvested stock (if the stock acquired on exercise of the stock option was vested, there would be no reason to make a Section 83(b) election).

Another common misconception is that Section 83 does not apply to restricted stock that is purchased at fair market value.  This is not true.  Section 83 applies even to stock that has been purchased at fair market value, if the stock is subject to a substantial risk of forfeiture and received in connection with the performance of services.  See this case, Alves v. Commissioner.

An 83(b) election has to be filed with the IRS within 30 days of receipt of the property, a copy has to be filed with the tax return of the person making the election, and a copy must be provided to the company.

Additional information about making the election can be found here.

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