506(c) Offerings: Let’s Fix the Verification Rules

Section 201(a) of the JOBS Act repealed the ban on generally soliciting or generally advertising private securities offerings, provided certain conditions were met.

Many people believed that this change in the law would be one of the most dramatic brought about by the JOBS Act. But things didn’t go as planned. Today, only a small fraction of private companies raising money generally solicit or generally advertise their offerings. Why is this? Because along the way to passage, the original Section 201(a) was amended to include what many people thought was a reasonable addition, and then the SEC enacted rules requiring something a lot of people don’t want to do.

Rule 506(c) Offerings

In Rule 506(c) offerings, a company can generally solicit or generally advertise that they are selling securities but only if:

  • All of the investors in the round are accredited, and
  • the issuer verifies that the investors are accredited.

The verification rules require companies to ask their investors for their personal tax returns, or their personal financial statements. These verification rules surprised a lot of angels, and essentially made Section 201(a) not quite the improvement in the law we all hoped it would be. Most angel investors don’t want to turn over their personal tax returns or personal financial statements as a condition to making an investment in a private company. Similarly, most private companies don’t want to put any more hurdles in front of receiving an investment than absolutely necessary.

This is the reason the overwhelming majority of private company securities offerings are still done the old fashioned way, without general solicitation or advertising. This is the the reason almost all companes proceed under Rule 506(b). Rule 506(b) offerings can’t be generally solicited or advertised–but they also don’t require verification. In a Rule 506(b) offering, you can rely on an investor checking a box averring that they are accredited, as long as your belief that they are accredited is reasonable.

I’ve quoted Section 201(a) below. The original Section 201(a) did not include the verification language. I have put in bold below the language that was added after a comment at a House Committee hearing that if companies didn’t verify the accredited investor status of their investors, non-accredited investors might be lured into risky investments and lose their money.

I am in favor of repealing this verification requirement, and returning to the original language of Section 201(a). Short of repeal, I think we should change the verification requirements to make them less intrusive, and more obervant of investors’ desire for personal privacy. Perhaps simply allowing investors to certify under penalty of perjury that they are accredited after reading the rules re accreditation and averring that they understand them would be a good compromise.

It would be nice to fix these rules so that Rule 506(c) would be more widely used.

The Language of Section 201(a)

Not later than 90 days after the date of the enactment of this Act, the Securities and Exchange Commission shall revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors. Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission. Section 230.506 of title 17, Code of Federal Regulations, as revised pursuant to this section, shall continue to be treated as a regulation issued under

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Intrastate Crowdfunding: SEC Adopts Helpful Rules

The SEC adopted final rules today to facilitate intrastate crowdfunding offerings.

Intrastate Crowdfunding

Intrastate crowdfunding is a phenomenon I am not sure many people anticipated. In the wake of the JOBS Act, when everyone was waiting for the SEC to finalize the Title III JOBS Act equity crowdfunding rules, states started passing their own laws. Amy Cortese has a really nice graphic on her site showing that 35 states so far have passed intrastate equity crowdfunding laws.

The new SEC rules will remove some of the impediments to intrastate crowdfunding. There are still things left to improve at the federal level to help intrastate crowdfunding, but today is a good day for the local investment movement.

Links to the SEC’s Press Release and the Final Rules

The SEC didn’t undermine existing state law. There was a risk of this. The SEC initially proposed rules that would have removed Rule 147 as a safe harbor under Securities Act Section 3(a)(11). This would have disrupted a number of state statutes. Instead, the SEC left Rule 147 in place, but amended it, and then adopted a new exemption designated Rule 147A.

The SEC also increased the amount that can be raised under Rule 504 to $5M (from $1M), applied the bad actor restrictions to Rule 504 offerings, and repealed the never used Rule 505.

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Intrastate Crowdfunding: SEC Meeting Next Wednesday

The SEC has announced that it is going to have a meeting next Wednesday, October 26, 2016, at 10:00 a.m. Eastern Time to consider whether to adopt rule amendments to facilitate intrastate crowdfunding offerings.

The SEC might adopt an entirely new exemption for intrastate crowdfunding offerings. The trouble with the current intrastate crowdfunding legal landscape is that Section 3(a)(11), the statutory basis for almost all state equity crowdfunding statutes, imposes unreasonable burdens on intrastate offerings.

It will be fun to see what the SEC does. We will keep you posted. If you want to tune in and watch the SEC hearing yourself, it should be on the sec.gov web site next Wednesday morning.

The proposed rules and comments to them can be found here:

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Qualified Small Business Stock: Redemption Issues

By Susan Schalla & Joe Wallin

If you are not familiar, Section 1202 of the Internal Revenue Code provides startup founders and investors with a very significant potential tax break on the ultimate sale of their stock, if the stock is “qualified small business stock.”

What is the Tax Break?

The tax break is a complete exclusion from tax on up to $10M on gain on the sale of qualified small business stock held for more than 5 years.

This is a per issuer/per company exclusion. Thus, you can exclude up to $10M in gain on every company you invest in if the stock you buy is qualified small business stock and you hold it for 5 years before you sell it.

What is Qualified Small Business Stock?

Qualified small business stock is:

  • stock in a C corporation (S corporation stock or interests in an LLC taxed as a partnership do not count)
  • engaged in a qualified small business
  • issued in exchange for money or other property or services.
Thus, your founder stock can qualify as qualified small business stock if you organize your startup as a C corporation, it has less than $50M in gross assets before and after you put your money in, and your business is not a services business (like a law firm).
You have to hold your founder stock for 5 years. But if you do, on the sale of the stock you can exclude up to $10M in gain from U.S. federal income tax entirely. If you don’t hold your founder stock for 5 years before sale, Section 1045 of the IRC has a friendly rollover provision.

This is probably the most significant tax break in startup land. But it only works if you form a C corp. If you and your co-founders form an S corp, your founder stock won’t qualify for the benefit. If you form an LLC, your LLC interests won’t qualify, but you can incorporate an LLC as a C corp and then start the clock.

We received the following question recently, and we wanted to share the answer as this can be a pretty typical scenario.


I’m considering joining a startup as a late-entry co-founder and want to make sure my shares get 1202 treatment if possible.

One problem is that one of the company’s co-founders left recently, and the company ‘automatically’ repurchased the unvested shares per the employment agreement, on the order of 25% of the total outstanding shares.

I looked up the statute and it seems that if the company buys back more than 5% of its shares from anyone (in the last 2 years), then no QSB shares can be issued for at least 2 years from that repurchase date.

Here is what the statute says:

(b) Significant redemptions
(1) In general. Stock is not qualified small business stock if, in one or more purchases during the 2-year period beginning on the date 1 year before the issuance of the stock, the issuing corporation purchases more than a de minimis amount of its stock and the purchased stock has an aggregate value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of the issuing corporation’s stock as of the beginning of such 2-year period.

Is my assessment correct? Would love to hear what you think. Thanks!


The statute does have a prohibition on redemptions. However, the Treasury Regulations contain an important exception for certain events, including when the company redeems shares of an employee or director upon their termination of service.

Here is what the regulations say:

(d) Exceptions for termination of services, death, disability or mental incompetency, or divorce. A stock purchase is disregarded if the stock is acquired in the following circumstances:
(1) Termination of services
(i) Employees and directors. The stock was acquired by the seller in connection with the performance of services as an employee or director and the stock is purchased from the seller incident to the seller’s retirement or other bona fide termination of such services.

This should cover many of the circumstances in which founders stock is repurchased on termination of service.

This blog post does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

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Employee Stock Ownership: Empowering It Through A New Law

Broad-based employee stock ownership is one way to ensure that the wealth created in startups is widely shared by those who helped create the wealth.

But broad-based stock ownership in private companies is thwarted by our tax code. Our tax code discourages the sharing of stock ownership among a company’s workers by taxing workers on the receipt of illiquid shares as if the shares could be sold to generate cash to pay the taxes.

We Need To Fix Our Tax Laws To Change This

The U.S. House of Representatives passed a bill recently entitled the “Empowering Employees through Stock Ownership Act.”

The purpose of the bill, as you might imagine, is to promote employee stock ownership. The bill attempts to do this by allowing corporations to transfer stock to their employees without the employees suffering an immediate tax hit. This is something I have been advocating for a while.

Currently, the tax law makes it hard for companies to share equity with their workers. How does it do this? By taxing the transfers of illiquid shares to employees as if the illiquid shares were cash.

Let’s do an example

Suppose you work for a private company. Let’s suppose the company wants to transfer you shares representing 1% of the company in consideration of your services to the company. If the company transfers fully-vested shares to you, you will have to pay tax on the value of the shares you receive as if you received cash equal to the value of the shares, and you used the cash to buy the shares.

If you are an employee, you will have to write the company a check to cover the employee side of income and employment tax withholding.

This quickly becomes prohibitively expensive for workers.

If your company transfers stock to you worth $100,000, for example, you will have to write a check to the company in excess of $25,000. (The supplemental income tax withholding rate is typically around the 25% range, and then on top of that is the employee side of FICA, which is 7.65% until you hit the FICA wage cap after which point the Hospital Insurance component is 1.45%). A lot of employees don’t have the money in the bank to send to the IRS and have to pass on the opportunity to own stock in the company they work for.

The work around here is a stock option–but stock options are not the same as stock ownership. Options have to be set to expire, and frequently optionees never realize the economic benefits of an option grant because their options expire.

H.R. 5719 aims to fix this

Below is a plain English summary of the bill from Congress.gov. The bill is not perfect. It attempts to do too many things, and it could be cut down in length and complexity. But it is fun to see Congress trying to fix our anti-worker tax code.

From Congress.gov:

Empowering Employees through Stock Ownership Act

This bill amends the Internal Revenue Code to allow an employee to elect to defer, for income tax purposes, income attributable to certain stock transferred to the employee by an employer.

The employee may defer the inclusion of income from the stock until the year that includes the earliest of the dates on which:

  • the stock is sold, exchanged, or otherwise transferred;
  • the employee becomes an excluded employee;
  • stock of the corporation becomes readily tradable on an established securities market;
  • seven years has passed after the rights of the employee in the stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier; or
  • the employee elects to include the amount in income.

The stock must meet specified requirements and be transferred to the employee from an eligible corporation in connection with the performance of services as an employee.

A corporation is eligible if: (1) no stock of the corporation is readily tradable on an established securities market during the year or any preceding year, and (2) it has a written plan under which at least 80% of all employees have the same rights and privileges to receive stock for the year.

Employees are excluded if they are or have been: (1) a 1% owner, the chief executive officer, or the chief financial officer of the corporation; (2) a family member of the specified individuals; (3) or one of the four highest compensated officers of the corporation.

The corporation transferring stock must notify employees regarding the option of deferring income and meet specified withholding and reporting requirements.

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S Corporations & Blank Check Preferred Stock

By Jordan Taylor, CPA and Joe Wallin

I have heard this a number of times:

“A corporation cannot make an S election if it has preferred stock authorized in its charter, even if the preferred stock is ‘blank check,’ meaning it doesn’t have any rights, preferences and privileges ascribed to it, and none of it has been issued.”

“Blank check” preferred is just preferred stock that is set aside and reserved for in the charter–but without any rights yet ascribed to it. People who form a new corporation often include blank check preferred in the charter.

For example, a corporation might have ten million (10,000,000) authorized shares, but those might be broken into nine million (9,000,000) common and one million (1,000,000) preferred. The preferred will be blank check. Again, this means that no rights have been ascribed to the preferred. No liquidation preference per share. No voting rights. Nothing.

Blank check preferred just sits there until the Board decides to ascribe the rights, preferences and privileges and actually issue the shares.

The Internal Revenue Code says that an S corporation cannot “have more than 1 class of stock.”

But what counts as “stock” for this purpose?

Here is a excerpt from an IRS publication on this point:

Unissued stock. Authorized but unissued stock and treasury stock are not considered in determining if a corporation has more than one class of stock…The existence of outstanding options, warrants to acquire stock, or convertible debentures will not, by itself, be considered a second class of stock.

There is also this from the regulations:

(3) Stock taken into account. Except as provided in paragraphs (b) (3), (4), and (5) of this section (relating to restricted stock, deferred compensation plans, and straight debt), in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds, all outstanding shares of stock of a corporation are taken into account. For example, substantially nonvested stock with respect to which an election under section 83(b) has been made is taken into account in determining whether a corporation has a second class of stock, and such stock is not treated as a second class of stock if the stock confers rights to distribution and liquidation proceeds that are identical, within the meaning of paragraph (l)(1) of this section, to the rights conferred by the other outstanding shares of stock.

There is also this, from an article written by Boris I. Bittker and James S. Eustice:

“One class of stock. The corporation may not have more than one class of stock. The regulations state that a class of stock is to be counted for this purpose only if it is issued and outstanding, so that treasury stock or authorized but unissued stock of a second class will not disqualify the corporation.”

In summary, merely having “blank check” preferred stock authorized in your charter does not blow your S election.

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RSUs: The Tax Problems in the Startup Context

Restricted Stock Units (RSUs) are not a good choice of equity compensation for a startup.

RSUs work great for big public companies, like Amazon or Microsoft. And sometimes RSUs can work great for private companies. But it has to be a really unique private company for RSUs to make sense. Examples would be a company ramping to its IPO, or a private company that is so profitable or has so much in cash that it can afford to help its employees pay the tax on their vesting unit awards. These are very unusual circumstances.

In most instances, if you are in a startup, your choice of equity award should be either stock options or restricted stock awards.

How do RSUs work?

The company awards you “Restricted Stock Units.” Each unit represents one share of stock to which you will become entitled once your units vest.

For example, you might get 40,000 RSUs, vesting in equal increments over 4 years of service. After 1 year of service, the company would issue you 10,000 shares of stock.

This sounds great, and it is, except for the tax problems.

The Tax Problems

When you receive the 10,000 shares in the example above, you will owe tax on the value of those 10,000 shares at the time the shares are issued. So, in the above example, if after 1 year of service the shares are worth $20 a share, you will owe tax as if you had received $200,000 in cash. You will have to write a check to your employer so that your employer can send your share of the federal income and employment taxes to the IRS. Or you will have to forfeit the shares instead of receiving them.

The tax withholding the company is obligated by law to collect from the employee on $200,000 of income is substantial. You will have to write a big check to the company, or the company won’t have to issue you your shares and you will forfeit them.

On $200,00 in value of vested RSUs, the income tax withholding will be about $50,000 (the supplemental wage withholding rate varies from time to time, but assume the current 25%). In addition to that, there will be FICA or Hospital Insurance taxes. Most employees do not have this kind of money to send to the IRS to receive shares in a private company which can’t be sold.

Big, public companies, like Amazon or Microsoft–can manage this problem. These companies can establish programs that allow their employees to get liquidity on their shares immediately to pay the taxes. This can’t be done in the private company context. So if you receive RSUs in a private company, with no public market for its shares, be careful. You might be stepping into an unexpected tax trap.

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Warrants: The Tax Story

By Dan Wright of Clark Nuber and Joe Wallin

Warrants can be confusing from a tax point of view. There are a couple of reasons for this. But the primary reason is probably because how a warrant is taxed is driven by the factual circumstances under which it was issued. Was it issued as part of an investment purchase transaction? Or was it issued as compensation for services rendered?

What is a Warrant Anyway?

A warrant is an agreement with a comany that entitles the holder of the warrant to purchase shares of the company, typically at a fixed price, over a set period of time (e.g., 2, 5, 7 or 10 years).

Thus, a warrant is simply an option to purchase shares, just like an employee stock option. However, warrants are not issued under a stock option or equity incentive plan. They are stand alone contracts, typically 5-10 pages in length.

Despite the fact that warrants are at some fundamental level the same thing as an employe option does not mean that the tax consequences of a warrant track the tax consequences of an employee stock option. The tax consequences can and do track if the warrant is a compensatory warrant issued for services. But if the warrant was received in connection with an investment transaction, the consequences are different.

The Taxation of the Investment Warrant

The investment warrant is a warrant received in connection with an investment into a company. The most typical example of this type of warrant is the warrant received in connection with the purchase of a convertible note. This warrant entitles the holder to purchase additional securities of the issuer. The “warrant coverage” is typically a percent of the amount invested. For example, the warrant coverage might be 25%. Meaning, that for every dollar invested, an additional $0.25 is available for the investor to purchase, pursuant to the warrant. The warrant typically has a 2 or 5 year term. So, if you invested $100,000 in a convertible note round, you would be entitled to purchase an additional $25,000 in the round, at the round’s ultimate price, at any time during the term of the warrant.

The taxation of an investment warrant is favorable. First off, a warrant issued in an investment transaction does not have to  be priced at FMV, like a compensatory warrant. It can be issued for a penny a share, for example, even if the last 409A valuation of the company indicated that the FMV of the common was greater than a penny a share. And, if you ultimately exercise the warrant and there is a spread between the exercise price and the value of the shares you receive on exercise, you do not have to pay tax on the spread on exercise. The reason is that you purchased the warrant when you bought the underlying securities. It was a purchase transaction, not a compensatory transaction

The Taxation of the Compensatory Warrant

The compensatory warrant is a warrant issued for services. Warrants issued for services are taxed just like compensatory stock options. If you receive a compensatory warrant, you are not taxed on the receipt of the warrant as long as the warrant is priced at fair market value. When you exercise, however, any spread is taxable as ordinary income.

The labeling of rights to purchase shares issued in the compensatory context as “warrants” rather than options can cause confusion regarding the tax treatment.

Does labeling the instrument as a warrant rather than an option change its tax treatment? No. The US federal income tax tax law doesn’t care what you call a thing. What matters is the character of the payment. If the payment is compensatory in nature, then the tax consequences follow the compensatory pattern.

The IRS recently issued a Letter Ruling that relates to this issue.

Letter Ruling 201610006 describes a situation where warrants were issued in exchange for services. The warrants entitled the service provider recipient to acquire a fixed amount of shares on two future dates. The warrants did not have an “ascertainable value” upon issuance. The warrants could be canceled if the service provider failed to perform. This contingency lapsed once the warrants were exercised.

The IRS concluded that the income associated with the warrants (i.e., the excess of the FMV over the purchase price) was not required to be recognized when the warrants were issued or when the contingency lapsed (i.e., when the services were performed). Instead, the income should be recognized when the warrant rights were exercised.

While Letter Rulings cannot generally be relied upon for audit protection, the Letter Ruling provides insight into Treasury’s thinking regarding how warrants should be treated when issued to a service provider.

Don’t let the label of a thing lead you to believe it has one tax result over another.

(This blog doesn’t constitute tax or legal advice. Always consult a tax or legal advisor with respect to your particular circumstances.)

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Crowdfunding Tax Advice From the IRS

Dan Wright and Joe Wallin

If you are going to raise money through a crowdfunding campaign, you need to think through the tax consequences before you start.

You might have to collect sales taxes. You might also have to pay federal income taxes on the funds you raise, in the year in which you receive them. Because the financial magnitude of the tax consequences, you need to think through the tax consequences to properly plan and budget your campaign.

The IRS has yet to issue significant and meaningful guidance on these issues specific to the new world of online crowdfunding. So when we saw that the IRS had issued an Information Letter on the topic, we were excited. We thought we might at last learn something interesting or meaningful.

The Trouble with Crowdfunding

The trouble with determining the taxes on a crowdfunding campaign can be the variety of things occurring in the campaign.

For example, in exchange for funds, the contributor might be entitled to equity in a new or existing company, products, services, loan repayment, or just nominal awards or acknowledgements.  In some cases, nothing is exchanged; the contributor simply makes a gift in the interest of supporting a worthy or novel effort.  In other cases, the funds are required to be returned to the contributor if the purpose of the fund raise fails to materialize.

The IRS Information Letter

The Treasury Department published the Information Letter (Information Letter 2016-0036) on March 30, 2016. The letter is exciting to start reading, because the question posed is pretty interesting:

What are “the income tax consequences of a crowdfunding effort to purchase a company through contributions for which the contributors will receive….”

And then the story trails off. The IRS doesn’t tell us what was being given in exchange. This makes it hard on us as readers.

If the recipients were receiving equity in the company, their contributions would generally not be taxable income. Corporations can issue stock for cash without income (IRC Section 1032). Similarly, contributions of cash to an LLC taxed as a partnership in exchange for interests in the LLC are not taxable (IRC Section 721).

But what happens if the contributors are receiving equity in the company, and receiving some spiffs as well. For example, what if the company being purchased was a restaurant, and all of the investors received 15 free dinners a year? What then?

General Tax Principles Apply

The IRS says general tax principles apply to the receipt of funds.

In general, money received without an offsetting liability, that is neither a capital contribution to an entity in exchange for a capital interest in the entity, nor a gift, is includable in income.

What this means is that crowdfunding revenues will generally be treated as taxable income if the revenues are not 1) loans that must be repaid, 2) a contribution to equity in exchange for an equity interest in a company, or 3) gifts.  The letter noted that some transfers without a “quid pro quo” attachment are not necessarily gifts for income tax purposes, but did not further elaborate on when a crowdfunding “gift” is not taxable revenue.

Clearly, the IRS will treat the funds as revenue when the funds are contributed in exchange for services, or for a product.  The letter also touches on when the funds must be reported.  With respect to timing, the letter cited general “constructive receipt” principles.   That means that the revenue must be reported in the period in which possession of the funds is no longer subject to “substantial limitations or restrictions.”  A self-imposed restriction doesn’t defer recognition of that income.

Request a Ruling?

Finally, the letter invites fund recipients to request a “private letter ruling” from the IRS regarding their specific facts.  While the private letter ruling process can be helpful in some circumstances, this process can involve significant preparation cost and generally takes considerable time before a response is received, particularly when arrangements are new or unconventional.

The letter leaves most crowdfunding recipients in the position of applying very general tax principles to their respective arrangements. Given that many crowdfunding arrangements are new and in some cases novel, applying general principles can be difficult, and will likely leave taxpayers subject to audit risk. It would be great if the IRS issued more guidance in this area.

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Stock Option Plan Administration: A Guide

Administering a stock option plan requires regular attention to compliance obligations.

Events to Watch Out For

There is work to do when:

  • the board of directors takes action to grant stock options, which can occur either at regularly scheduled board meetings or at any time at special board meetings or actions by unanimous written consent;
  • optionees exercise their stock options, or have questions about how their options work;
  • optionees leave the service of the company; and
  • the company is fulfilling its tax reporting obligations.

The Importance of Doing This Right

Failure to administer a company’s stock option plan in compliance with law can result in severe penalties to the company and the individuals involved. For this reason, you should approach administering a stock option plan with a high degree of care. Wrongly administered, you might become subject to SEC or state regulatory action. A financing could be delayed. Or an exit transaction could be put on hold.

Order of Optionee Paperwork

When you bring on a new employee, you will frequently include language in the offer letter about the expected option grant. The offer letter should state that the option remains “subject to Board approval.” You shouldn’t deliver the actual option paperwork until the Board approves the grant in a meeting or via unanimous Board consent.

What To Do Before Every Board Meeting or Board Consent to Grant Options

Before every set of stock option grants, you need to take the following actions:

  • Review the proposed list of optionees. Do you have any optionees located in states in which you might need to make a filing with the securities regulator in order to grant options in that state? Each state’s laws are different. Some states require filings and the payment of fees to grant options to an optionee resident in that state (e.g., California); other states have self-executing exemptions provided your plan is administered in accordance with federal Rule 701. Because each state is different, you need to be careful whenever granting options to any optionee located outside of your home state (where you presumably have already done the compliance work to grant options to optionees living in that state). We maintain a 50 state guide to assist in this process.
  • Do you have enough shares authorized and available for use in your plan? Increases in plan share reserves or the adoption of a new plan will likely involve stockholder approval as well as board approval.
  • Make sure you are updating your stock register.
  • Do the proposed stock option grants cause you to run over Rule 701’s mathematical limitations? Remember, Rule 701 has absolute mathematical limitations that you cannot go over. There are three different measurements, and you only have to comply with one of them, but companies can easily surpass the limits of they are not paying attention to this issue.
  • Do the proposed stock option grants cause you to have granted more than $5M in equity awards in the last 12 months, meaning you have a prospectus delivery requirement to meet?
  • Have you determined the current fair market value of the stock? Are the options being granted at no less than that fair market value? Has there been a material event since the company’s last 409A valuation?
  • Are you in the 409A waiting period, when you cannot grant options until the 409A valuation is complete? This delay can occur when your 409A valuation report is in process and you don’t know the current fair market value of the stock.

What To Do On Every Option Exercise

  • Review the optionee’s option exercise form, and ensure it has been correctly completed.
  • Go back and make sure that you have a set of board minutes or a board consent granting the options (this should be easy to find, and arguably this step is unnecessary because you should have made sure that every option grant was approved by the Board before you gave the optionee the paperwork, but it is always a good idea to go back and check the records to ensure that they are in order).
  • If the option is an incentive stock option, prep the employee on the alternative minimum tax consequences.
  • If the option is a nonqualified stock option granted to an employee, and it is being exercised at a gain, calculate the income and employment tax withholding amounts the employee must pay the employer to exercise the options. Your withholding obligation exists if the optionee was an employee at the time of grant, regardless of whether the employee is or is not an employee at the time of exercise. See this blog post: http://thestartuplawblog.com/nonqualified-stock-options-tax-withholding/

What To Do When People Leave

When optionees leave, their options revert to the plan if not exercised. Be sure to update your stock option ledger when this occurs.

End of Year Tax Compliance Dates

  • By January 31st, Forms W-2 and Forms 1099 need to be delivered to employees and contractors: (i) Who exercised stock options during the year in which there was a gain; and (ii) Who received stock awards or stock bonuses that resulted in income to the recipient.
  • By January 31st, deliver Form 3921 to employees who exercised incentive stock options during the prior year https://www.irs.gov/uac/Form-3921,-Exercise-of-an-Incentive-Stock-Option-Under-Section-422(b).
  • By February 28, file Copy A of Form 3921 with the IRS with respect to ISO exercises in the prior year. If you file electronically, the due date is March 31 of the year following the year of exercise of the ISO.
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