The Startup Law Blog

If you have run a successful crowdfunding campaign, you know what happens next. You owe a lot of crowdfunding sales tax. And you might not have appreciated what you were getting yourself into on the crowdfunding sales tax front.

Crowdfunding Sales Tax Troubles

There is a bill that has been introduced in the Washington State legislature that will attempt to alleviate or fix this problem.

The bill is HB 2655. You can track it here.

There will be hearing on this bill on January 29, at 8:00 a.m., in Olympia.

If you care about this issue, you can drive down to Olympia and sign up to testify in favor of the bill.

Please participate in this issue if you can. I like what the preamble to the bill says:

The legislature finds that crowdfunding plays an increasingly vital role in the economy and in individual communities, and that the global crowdfunding market will surpass ninety billion dollars in the next ten years. The legislature further finds that the current business and sales tax structure of Washington state is an impediment to entrepreneurs, inventors, artists, and private citizens seeking financial contributions to start new businesses, develop new products, complete creative projects, and achieve various goals. The legislature further finds that the current crowdfunding tax structure treats crowdfunding campaigns differently depending on their structure. It is the intent of the legislature to provide a business tax exemption for crowdfunding donations and to improve the sales tax structure as it applies to crowdfunding in order to simplify the tax code, improve fairness, and promote economic growth.

The idea that you can “test in” to accredited investor status is gaining momentum.

Rep. Schweikert (R-Ariz.) has introduced a bill that would do just that. His bill has passed out of the House Financial Services Committee and is apparently headed to the floor of the House.

You can track the progress of the bill here.

The full text of the bill is quoted below:

SECTION 1. SHORT TITLE.

This Act may be cited as the “Fair Investment Opportunities for Professional Experts Act”.

SEC. 2. ACCREDITED INVESTOR DEFINITION.

Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall revise its rules under Regulation D (17 C.F.R. 230.501 et seq.) to provide that a natural person shall be considered an accredited investor under such regulation notwithstanding the income and net worth requirements in paragraphs (5) and (6) of section 230.501(a) of title 17, Code of Federal Regulations, if such person certifies to the issuer prior to the sale of securities to such person that he or she—

(1) is a person described in paragraphs (1), (2), (3), or (4) of section 506(c)(2)(ii)(C) of such title;

(2) has retained and used the services of any person referred to in paragraph (1) to make an investment decision relative to the securities being offered; or

(3) is licensed as an accredited investor by the Financial Industry Regulatory Authority after completing an exam administered by such Authority using the criteria established by the Securities and Exchange Commission under section 2.

SEC. 3. FINRA LICENSING PROGRAM.

Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall establish criteria for use by the Financial Industry Regulatory Authority in administering an exam to license as accredited investors natural persons who don’t meet the income and net worth requirements in paragraphs (5) and (6) of section 230.501(a) of title 17, Code of Federal Regulations. Such criteria may include methods for assuring that licensed accredited investors demonstrate a competency in understanding the following:

(1) The different types of securities.

(2) The disclosure obligations under the securities laws of issuers versus private companies.

(3) The structures of corporate governance.

(4) The components of a financial statement.

(5) Other criteria the Commission shall establish in the public interest and for the protection of investors.

You might be wondering: Who are the folks specified in paragraphs (1), (2), (3), or (4) of section 506(c)(2)(ii)(C). This is the group:

1. A registered broker-dealer;
2. An investment adviser registered with the Securities and Exchange Commission;
3. A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
4. A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.

I am a fan of this idea. The SEC staff also suggested a way to test into accredited investor status in its recent report on the accredited investor definition.

I can hear the other side. The arguments will be–these folks might have the financial sophistication, but be unable to bear the economic loss. Therefore, they shouldn’t be allowed to test in. I don’t agree. If anything, the response to this is–ok, then limit the amount such persons can invest in any one company.

This will be a fun thing to watch develop. I hope it moves forward. I would like to take the test myself, just to see how I would do.

In its report, the SEC had some ideas on how the test could be assembled from parts of other exams.

Portions of FINRA’s Series 7 and Series 82 examinations cover these areas and could potentially be used as a model for developing an accredited investor examination. Among other subjects, the Series 7 examination covers securities regulatory requirements, securities characteristics and financial analysis. Knowledge of the regulatory landscape is particularly important because individuals who invest in unregistered offerings should understand that they will generally not receive the type of information contained in a registration statement. The Series 7 examination consists of 250 multiple choice questions that candidates have six hours to complete. Among other subjects, the Series 82 examination similarly includes questions related to the regulation of the markets for registered and unregistered securities, securities characteristics and financial analysis. The scope of the Series 82 examination is more limited than the Series 7 examination because it focuses on private transactions. It contains 100 multiple choice questions that candidates have two-and-a-half hours to complete….

It will be fun to watch the legal/regulatory developments here, to let people test in.

For more related articles, visit our website, here.

If you are in the process of awarding stock options to employees or service providers, do not forget that you need (among other things) board approval of all stock option grants. This is required by the corporate law of Delaware, Washington, and I imagine almost every state corporate law in the country.

(In this post, I am not talking about LLC equity awards; LLC equity awards are something entirely different from corporate stock options.)

Board approval of options can be documented in minutes of a board meeting, or a unanimous written consent of the board.

You can find good examples of board minutes granting options, or board consents granting options, if you search on Google. But I would recommend you use your company’s law firm’s documents. They will have them to share with you. And they would probably prefer you use their forms, since they might be called upon at some future point in time to give a legal opinion on your capitalization, and it will help them do that if they have been involved with your equity issuances.

Why is it important that you promptly and fastidiously document board approval of stock option grants? Well, because if the options haven’t been approved by the board, they haven’t been appropriately awarded under the corporate law. This can give rise to a variety of complexities and problems.

In general, it is a good idea to check in with your corporate counsel before granting stock options. This does not have to be an expensive process, but the costs of not administering your stock option plan in compliance with all of the technical requirements can become very expensive.

For example, if you run over the Rule 701 mathematical limitations, it could actually delay your IPO or result in personal fines. This actually happened to Google. You can find more information about this in this Practical Law Article.

Below is a full-blown stock option grant checklist.

Prior to Granting Stock Options

• Adopt a stock option plan – First, adopt a plan and draft standard stock option agreements under the plan. If shareholders do not approve the plan, you cannot grant incentive stock options, and you may be required to make special filings with state securities regulators.
• Grant all of your stock options under the plan-If you are granting options outside the plan, special considerations will arise, which are not addressed in this checklist.
• Confirm that you have sufficient shares- Prior to granting stock options; confirm you have the number of shares under the plan to grant the new batch of options.
• Rule 701- Before every grant of stock options, confirm that you are compliant with Rule 701′s mathematical limitations. Rule 701 has mathematical limitations, meaning–there is a limit to the number of securities you can issue under Rule 701, and you do not want to exceed that limit. For a summary of the limits, see What Is Rule 701 and Do I Need to Worry About It? [Be aware that Rule 701 is only available to companies that are not subject to the reporting requirements of section 13 or 15(d) of the Securities Exchange Act]
• Prospectus- If you have granted more than $5M in options during the last 12 months, make sure to provide the prospectus required by Rule 701.
• Eligible recipients- Confirm each prospective option recipient is eligible under the plan. Generally, only individuals qualify. Non-employee/consultants can qualify as long as they are natural persons providing bona fide services and not receiving the options in connection with a capital raising transaction.
• Confirm the residency of recipients – Before every grant of stock options, confirm the residency of the prospective optionees and confirm that you are compliant with the Blue Sky law of each state in which investors are resident. If you are granting options to optionees in California, special attention will need to be given to California’s requirements.
• Fair market value- Make sure that the options are being granted at fair market value in compliance with Section 409A of the Internal Revenue Code.
• Board approval- Have the Board approve the option grants pursuant to a Board Consent or resolutions adopted at a meeting. If the vesting schedules for any of the options are different from the standard specified in the standard agreements, make sure the Board consent describes the vesting schedule.
• Signed agreements- After each grant of stock options, give each recipient a copy of the stock option plan and their stock option agreements, and have them sign the agreements required under the plan.
• Capitalization ledger- Update the capitalization ledger once the option is approved.

If you want to comment on the SEC’s proposed amendments to Rule 147, the deadline is Monday.

Rule 147: What Has The SEC Proposed

In general, what the SEC has proposed are good improvements to the law. For example:

• a company using the newly proposed Rule 147 would not have to be incorporated in the state in which it operates and where its investors come from. For example, a Washington headquartered company could be incorporated in Delaware.
• a company could advertise in a manner that crossed state lines “so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located.”
• the standards set forth in the current Rule 147 for determining whether a business was local enough would become more reasonable.

This is all good news.

The Hitch

However, the hitch is this–the proposed rules would potentially wreak havoc with state crowdfunding laws.

Let me give you an example.

Washington’s crowdfunding statute says that a company using it has to comply with both Section 3(a)(11) of the Securities Act of 1933 and Rule 147. (Washington’s statute says: “The offering is conducted in accordance with the requirements of section 3(a)(11) of the securities act of 1933 and securities and exchange commission rule 147, 17 C.F.R. Sec. 230.147″.)

The trouble with the SEC’s proposed rules is this: they remove Rule 147 as a safe harbor under Section 3(a)(11) and make Rule 147 its own stand alone exemption–because the newly proposed Rule 147 is not consistent with the Section 3(a)(11) statutory language.

So, if the SEC adopts its proposed rules as proposed, it will set up a quandary under the Washington law. How can a company comply with both Section 3(a)(11) and Rule 147 if they are different exemptions, and not necessarily consistent with one another?

The SEC has indicated in its proposed rules that it thinks that the various states that have enacted state crowdfunding laws (20+ now) can just amend their statutes. This is easier said than done.

Here is what the SEC says:

We recognize that none of the existing state crowdfunding provisions contemplate reliance upon the proposed amendments to Rule 147 and that states that have crowdfunding provisions based on compliance with Section 3(a)(11), or compliance with both Section 3(a)(11) and Rule 147, would need to amend these provisions in order for issuers to take full advantage of these amendments.

True, perhaps this can all be addressed by regulatory action in the various states that have enacted statutes requiring compliance with both Section 3(a)(11) and Rule 147. But it strikes me as fundamentally fair that the SEC’s final rules say something along the lines of the following:

“Existing Rule 147 will continue to be a safe harbor under Section 3(a)(11).”

In other words, let’s put a clause in that doesn’t require state legislatures to amend their statutes as a result of new SEC rules.

And the SEC asks for comments just along these lines. See questions 49 and 50:

Request for Comment

49. Should we leave existing Rule 147 in place and unchanged as a safe harbor for compliance with Section 3(a)(11) while adopting the proposed revisions to Rule 147 as a new rule instead? For example, if we were to repeal Rule 505 of Regulation D, should the Commission adopt the proposed revisions to Rule 147 as new Rule 505 of Regulation D? If so, are there any additional changes to the proposed rule that should be made if it were to be adopted instead as a new rule? If so, please explain what changes are needed and why.

50. States that have adopted crowdfunding provisions based on current Rule 147 may need to consider the import of any final rule amendments at the federal level. How would the proposed amendments to Rule 147 impact these provisions? Would the Commission’s rulemaking process, which in this case provides for a 60-day comment period, and the additional time before any final rules potentially would be adopted and thereafter become effective, provide sufficient time for states to consider and address the impact of the proposed amendments on their state law provisions? Why or why not? Please explain.

Here is what one commentator said:

3. The Commission should retain existing Rule 147.
As noted in the Proposing Release, the proposed amendments would no longer satisfy the parameters of Section 3(a)(11) of the Securities Act. Therefore, the Commission must adopt the proposed rule pursuant its authority under Section 28 of the Securities Act. At the same time, the Commission does not claim that current Rule 147 is inconsistent with either Section 3(a)(11) or judicial interpretations of the statute. Although the Proposing Release states that issuers may continue to “to rely on judicial and administrative interpretive positions on Rule 147 issued prior to the effectiveness of any such final rules”, the Commission is silent on reliance on current Rule 147. Nothing in the Commission’s proposal suggests that current Rule 147 is incorrect and issuers should be able to continue to rely upon it as a safe harbor. The Commission should avoid creating unnecessary uncertainty by retaining existing Rule 147.

The SEC staff has issued its first report on the definition of the term “accredited investor.”

Dodd-Frank requires the SEC to review and report on the definition of “accredited investor” every four years:

to determine whether the definition should be modified or adjusted for the protection of investors, in the public interest, and in light of the economy.

(Dodd-Frank was also the law that disallowed counting an investor’s equity in their primary residence toward the $1M net worth standard.)

The term “accredited investor” is probably the most important defined term in the law of startups. If the SEC was to radically increase the financial thresholds to be an accredited investor, the supply of capital to startups would be cut off.

Thus, it is in the startup community’s best interest to stay actively involved in the dialogue surrounding how this term’s definition will evolve over the coming years. This is not going to be a one time discussion. Dodd-Frank requires this review every four years. So, every four years we have something great to look forward to–a discussion about a very important aspect of the law.

In this, the first report, the SEC staff recommended that the Commission consider any one or more of the following methods of revising the definition:

• “The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:
  • Leave the current income and net worth thresholds in place, subject to investment limitations.
  • Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
  • Index all financial thresholds for inflation on a going-forward basis.
  • Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
  • Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
  • Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.”
• The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:
  • Permit individuals with a minimum amount of investments to qualify as accredited investors.
  • Permit individuals with certain professional credentials to qualify as accredited investors.
  • Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
  • Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
  • Permit individuals who pass an accredited investor examination to qualify as accredited investors.”

You might be curious by what the SEC staff means by “investment limitations.” Here the idea is that no angel investor would be able to invest more than 10% of their income or net worth in any one company.

There are a lot of good ideas in the report:

(1) same sex couples should not be disadvantaged by the way the rules work (it is wrong if the law would do it any other way);

(2) Indian tribes and other entities that currently don’t fall within the list of entities that can qualify as accredited investors should qualify as “accredited investors” if they have at least $5M in investment assets (I agree);

(3) allow persons to take a test to qualify as an accredited investor (I especially like this idea).

But I don’t like the idea of indexing the financial thresholds to inflation. What this will essentially put in motion is a continual cutting off of the pool of accredited investors. Slowly over time, inflation becomes a very powerful force. I did not see any analysis in the SEC’s report about how inflation will slowly reduce the number of accredited investors in places where angels are arguably needed most–like the interior of America.

If you want to comment on the SEC’s work, you can do so at this link.

Now that the qualified small business stock 100% tax exclusion is going to be permanent, one question that will come up more often is:

Qualified Small Business Stock Options

Do optionees qualify? Meaning, do holders of compensatory stock options, who exercise those options and acquire stock–can they qualify for the Section 1202 qualified small business stock benefit?

The answer is yes. Stock acquired upon the exercise of compensatory stock options can qualify as small business stock.

Specifically, Internal Revenue Code Section 1202 Says:

(c) Qualified small business stock. For purposes of this section—

In the big tax bill the Congress just passed, Congress made the 100% exclusion for gain on qualified small business stock held for more than five years permanent.

You can find the text of the bill at Congress.gov.

Qualified Small Business Stock

You might remember that the Congress has extended the 100% exclusion several times, but only for limited periods of time. Last year, in December, it extended the 100% exclusion for stock issued before January 1, 2015. So, in other words, in December 2014, the Congress only covered off 2014 and didn’t help us with 2015.

This time the Congress has extended the benefit permanently.

Here is how the bill did it:

SEC. 126. EXTENSION OF EXCLUSION OF 100 PERCENT OF GAIN ON CERTAIN SMALL BUSINESS STOCK.
(a) In General.—Section 1202(a)(4) is amended—

(1) by striking “and before January 1, 2015”, and

(2) by striking “, 2011, 2012, 2013, AND 2014” in the heading thereof and inserting “AND THEREAFTER”.

(b) Effective Date.—The amendments made by this section shall apply to stock acquired after December 31, 2014.

The Old Statutory Language

Here is how Section 1202(a)(4) used to look:

(4) 100 percent exclusion for stock acquired during certain periods in 2010, 2011, 2012, 2013, and 2014

In the case of qualified small business stock acquired after the date of the enactment of the Creating Small Business Jobs Act of 2010 and before January 1, 2015—

(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.

In the case of any stock which would be described in the preceding sentence (but for this sentence), the acquisition date for purposes of this subsection shall be the first day on which such stock was held by the taxpayer determined after the application of section 1223.

The New Statutory Language

And now, with the amendments, here is how Section 1202(a)(4) now reads:

(4) 100 percent exclusion for stock acquired during certain periods in 2010 and thereafter

In the case of qualified small business stock acquired after the date of the enactment of the Creating Small Business Jobs Act of 2010—
(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.
In the case of any stock which would be described in the preceding sentence (but for this sentence), the acquisition date for purposes of this subsection shall be the first day on which such stock was held by the taxpayer determined after the application of section 1223.

What Was the Date of Enactment of the Creating Small Business Jobs Act of 2010?

September 27, 2010

What is the Practical Meaning?

If you plan to form a startup, the potential of the qualified small business stock benefit is something to keep in mind. It may influence your decision as to what type of entity to form, or as to whether to make an S election (S corp stock doesn’t qualify).

Remember, the exclusion has a cap–but a substantial one–it can be as much as $10M.

This is good news for the startup world. It helps founders of C corps, and investors in C corps.

[This blog does not constitute tax advice, or the formation of an attorney-client relationship. Always consult with your own tax advisor about the particulars of your situation.]

For more articles like this, please visit our website, here.

You might be wondering about the status of the 100% tax exclusion for qualified small business stock acquired during certain periods and held for more than five years.

Late last year, the Congress extended the 100% tax exclusion for qualified small business stock acquired:

1) after the date of the enactment of the Creating Small Business Jobs Act of 2010 (the President signed this bill on September 27, 2010) and

2) before January 1, 2015.

In other words, the 100% exclusion doesn’t currently cover qualified small business stock acquired during 2015.

You can find the bill that Congress passed late last year at this Congress.gov link.

I wrote a blog post about last year’s Congressional action that you can find here.

The Congress has extended the 100% benefit a couple of times now, including retroactively. But it does not appear that Congress is going to do the same thing this year that it did last year. In other words, it does not appear that Congress is going to renew this December the 100% exclusion retroactively to cover qualified small business stock acquired in 2015.

The QSB benefit does not currently help people who acquired stock during 2015.

Deloitte wrote a good piece on this on January 30th of this year. As Deloitte states:

Through subsequent legislation, including the recently enacted TIPA of 2014, the exclusion has been extended for QSBS acquired through December 31, 2014.

There is still hope. Perhaps Congress will tackle this next year.

(Remember, the 100% exclusion has caps. It is not unlimited.)

This blog does not constitute legal or tax advice. In all instances you should visit your legal or tax advisor with regards to your personal tax situation.

Deferred salary or deferring salaries is an alluring trap in startup land. A company’s runway gets shorter. The company wants to extend its runway. It can be tempting for the founders to start “deferring” salary. Maybe some non-founder employees start deferring salary too.

Deferred Salary: The problems?

What are the problems with simply deferring salary?

• Under Section 409A of the federal income tax law, if a “nonqualified deferred compensation plan” doesn’t meet the requirements of Section 409A, then the employee has to include all of the deferred compensation in taxable income, plus pay a 20% penalty and interest.  In other words, simply “deferring salary” without working through the complex requirements of Section 409A is not a good approach.
• Are you reflecting the deferred amounts on the company’s balance sheet? If not, then you are probably running afoul of GAAP in some way. And, your balance sheets won’t be in a format suitable to present to potential investors.
• Are you aware that some states impose personal liability on directors and officers for failure to pay wages? You could be subjecting yourself to these claims.

So, what to do?

Don’t defer salaries. Reduce salaries. Get folks to agree in writing that their salary has been reduced. Then, if you want, you can agree to pay a “bonus” upon the occurrence of a well-defined milestone that includes a substantial risk of forfeiture. When you craft this bonus plan, you do need to be careful to comply with Section 409A. However, drafting a bonus plan to comply with Section 409A is quite a bit easier than navigating through the “deferral” rules for deferred salary amounts.

Bottom line: Reduce salaries. Don’t defer unless you really want to take the time to do it right.

About Carney Badley Spellman, P.S.

Carney Badley Spellman is about Advocacy, Strategy, Results. Located in Seattle, we are a full-service law firm committed to exceptional client service and professional excellence. Our firm serves individuals and businesses of all types and sizes. Also, our attorneys work with closely-held companies to Fortune 500 corporations in the Pacific Northwest and across the United States. Although Carney Badley Spellman‘s location is in Seattle, Washington, we are proud to be a part of the Washington state community and communities across the nation.

If your company has had employees exercise incentive stock options (“ISOs”), you are required to report certain information to the IRS and the optionee about the exercise.

ISO Tax Reporting

There is no income or employment tax withholding required on the exercise of an ISO. But there is an annual tax reporting obligation to the IRS and the employee.

You have to provide the employee with Form 3921 by January 31st of the year following the year of exercise.

You have to file the Form 3921 with the IRS by February 28 of the year following the year of exercise of the ISO (unless you file electronically in which case the due date is March 31 of the year following the year of exercise).

Here is what Form 3921 looks like:

Where to Find the IRS’s Instructions and the Form Itself

Here is the IRS’s web site on this issue.

The Information Required to be Reported

The form requires you to give the IRS and each employee exercising an ISO the following key information:

• The date of the option grant;
• The date of option exercise;
• The exercise price per share;
• The fair market value per share on the date the option was exercised;
• The number of shares exercised; and
• The name, address, and employer identification number (EIN) of the corporation whose stock is being transferred pursuant to the exercise of the option, if the corporation is not the entity shown in the TRANSFEROR boxes in the upper left corner of Form 3921.

The employee will need this information to calculate what taxes they might owe on the ISO exercise. Again, there is no ordinary income tax due on the exercise of an ISO, but the spread on exercise is an AMT adjustment. The AMT liability on the exercise of an ISO can be significant. In fact, during the dot com boom/bust many employees exercised ISOs and owed more in AMT than the stock was worth when they finally figured out their tax obligations.

There was so much political fallout from this that Congress actually passed a one time exemption for people who still hadn’t paid their AMT taxes years later (but didn’t provide a refund for people who had).

What is the lesson from all of this? Be aware of the potential magnitude of the AMT when exercising ISOs.

For more articles like this, please visit our website, here. If you wish to contact me, Joe Wallin, please click here.