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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). |
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.
Continue Reading...Please provide comments on this preliminary draft bill.
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.
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.
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.
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."
Continue Reading...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.
Continue Reading...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.
Continue Reading...The US House of Representatives today voted to subject the carried interest to tax as ordinary income and employment taxes.
Continue Reading...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.
Continue Reading...|
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Davis Wright Tremaine LLP, Davis Center 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. Please join us for a very educational discussion and chance to talk to experts in the field! |
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:
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 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) |
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."
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.
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."
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.
Continue Reading...
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.
Continue Reading...
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."
Continue Reading...
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):
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).
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:
“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."
"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."
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:
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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