The Startup Law Blog

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.

The RAISE Act would allow holders of stock in private companies to more easily sell their shares. Sales of private company stock are known as “secondary transactions.” Secondary transactions are currently hard to do because of the securities law restrictions on sales of shares in private companies, and also because companies frequently impose a number of contractual limitations on share resales (such as rights of first refusal).

However, even though share resales are currently difficult does not mean that they do not occur. Facebook stockholders found a healthy secondary market for their shares before Facebook went public. But Facebook is the clear exception–for most private companies no secondary market exists. This is in part due to the law in this area.

The securities laws impose significant limitations on share issuances and share transfers. This makes sense in a lot of instances (when people are being scammed). In other circumstances, restricting share transfers doesn’t seem to have as sound a public policy rationale. Allowing workers to more easily transfer shares they received as part of their compensation makes the law more fair to them, for sure. The new law would require that the purchasers be accredited investors, and that certain information about the company be supplied to the purchaser.

The Raise Act was embedded in the highway bill that passed both the House and the Senate and is on the way to the President’s desk.

We will see how soon the President signs it. Unfortunately, as the end of 2015 nears, it does not appear that the 100% tax exclusion from qualified small business stock held for more than five years is not going to be retroactively renewed like last year.

Text of The Raise Act

TITLE LXXVI—REFORMING ACCESS FOR INVESTMENTS IN STARTUP ENTERPRISES

SEC. 76001. EXEMPTED TRANSACTIONS.

(a) Exempted Transactions.—Section 4 of the Securities Act of 1933 (15 U.S.C. 77d) is amended—

(1) in subsection (a), by adding at the end the following new paragraph:

“(7) transactions meeting the requirements of subsection (d).”;

(2) by redesignating the second subsection (b) (relating to securities offered and sold in compliance with Rule 506 of Regulation D) as subsection (c); and

(3) by adding at the end the following:

“(d) Certain Accredited Investor Transactions.—The transactions referred to in subsection (a)(7) are transactions meeting the following requirements:

“(1) ACCREDITED INVESTOR REQUIREMENT.—Each purchaser is an accredited investor, as that term is defined in section 230.501(a) of title 17, Code of Federal Regulations (or any successor regulation).

“(2) PROHIBITION ON GENERAL SOLICITATION OR ADVERTISING.—Neither the seller, nor any person acting on the seller’s behalf, offers or sells securities by any form of general solicitation or general advertising.

“(3) INFORMATION REQUIREMENT.—In the case of a transaction involving the securities of an issuer that is neither subject to section 13 or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m; 78o(d)), nor exempt from reporting pursuant to section 240.12g3–2(b) of title 17, Code of Federal Regulations, nor a foreign government (as defined in section 230.405 of title 17, Code of Federal Regulations) eligible to register securities under Schedule B, the seller and a prospective purchaser designated by the seller obtain from the issuer, upon request of the seller, and the seller in all cases makes available to a prospective purchaser, the following information (which shall be reasonably current in relation to the date of resale under this section):

“(A) The exact name of the issuer and the issuer’s predecessor (if any).

“(B) The address of the issuer’s principal executive offices.

“(C) The exact title and class of the security.

“(D) The par or stated value of the security.

“(E) The number of shares or total amount of the securities outstanding as of the end of the issuer’s most recent fiscal year.

“(F) The name and address of the transfer agent, corporate secretary, or other person responsible for transferring shares and stock certificates.

“(G) A statement of the nature of the business of the issuer and the products and services it offers, which shall be presumed reasonably current if the statement is as of 12 months before the transaction date.

“(H) The names of the officers and directors of the issuer.

“(I) The names of any persons registered as a broker, dealer, or agent that shall be paid or given, directly or indirectly, any commission or remuneration for such person’s participation in the offer or sale of the securities.

“(J) The issuer’s most recent balance sheet and profit and loss statement and similar financial statements, which shall—

“(i) be for such part of the 2 preceding fiscal years as the issuer has been in operation;

“(ii) be prepared in accordance with generally accepted accounting principles or, in the case of a foreign private issuer, be prepared in accordance with generally accepted accounting principles or the International Financial Reporting Standards issued by the International Accounting Standards Board;

“(iii) be presumed reasonably current if—

“(I) with respect to the balance sheet, the balance sheet is as of a date less than 16 months before the transaction date; and

“(II) with respect to the profit and loss statement, such statement is for the 12 months preceding the date of the issuer’s balance sheet; and

“(iv) if the balance sheet is not as of a date less than 6 months before the transaction date, be accompanied by additional statements of profit and loss for the period from the date of such balance sheet to a date less than 6 months before the transaction date.

“(K) To the extent that the seller is a control person with respect to the issuer, a brief statement regarding the nature of the affiliation, and a statement certified by such seller that they have no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.

“(4) ISSUERS DISQUALIFIED.—The transaction is not for the sale of a security where the seller is an issuer or a subsidiary, either directly or indirectly, of the issuer.

“(5) BAD ACTOR PROHIBITION.—Neither the seller, nor any person that has been or will be paid (directly or indirectly) remuneration or a commission for their participation in the offer or sale of the securities, including solicitation of purchasers for the seller is subject to an event that would disqualify an issuer or other covered person under Rule 506(d)(1) of Regulation D (17 CFR 230.506(d)(1)) or is subject to a statutory disqualification described under section 3(a)(39) of the Securities Exchange Act of 1934.

“(6) BUSINESS REQUIREMENT.—The issuer is engaged in business, is not in the organizational stage or in bankruptcy or receivership, and is not a blank check, blind pool, or shell company that has no specific business plan or purpose or has indicated that the issuer’s primary business plan is to engage in a merger or combination of the business with, or an acquisition of, an unidentified person.

“(7) UNDERWRITER PROHIBITION.—The transaction is not with respect to a security that constitutes the whole or part of an unsold allotment to, or a subscription or participation by, a broker or dealer as an underwriter of the security or a redistribution.

“(8) OUTSTANDING CLASS REQUIREMENT.—The transaction is with respect to a security of a class that has been authorized and outstanding for at least 90 days prior to the date of the transaction.

“(e) Additional Requirements.—

“(1) IN GENERAL.—With respect to an exempted transaction described under subsection (a)(7):

“(A) Securities acquired in such transaction shall be deemed to have been acquired in a transaction not involving any public offering.

“(B) Such transaction shall be deemed not to be a distribution for purposes of section 2(a)(11).

“(C) Securities involved in such transaction shall be deemed to be restricted securities within the meaning of Rule 144 (17 CFR 230.144).

“(2) RULE OF CONSTRUCTION.—The exemption provided by subsection (a)(7) shall not be the exclusive means for establishing an exemption from the registration requirements of section 5.”.

(b) Exemption In Connection With Certain Exempt Offerings.—Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended—

(1) by redesignating the second subparagraph (D) and subparagraph (E) as subparagraphs (E) and (F), respectively;

(2) in subparagraph (E), as so redesignated, by striking “; or” and inserting a semicolon;

(3) in subparagraph (F), as so redesignated, by striking the period and inserting “; or”; and

(4) by adding at the end the following new subparagraph:

“(G) section 4(a)(7).”.

A lot of companies, including a large portion of Silicon Valley startups, grant new hires immediately exercisable ISOs (incentive stock options) with the expectation that many will exercise their options “early” for favorable tax treatment. In fact, employees are often given a kit with all the paperwork, including everything needed to exercise and file an 83(b) election with the IRS.

In general, this is a nice offer. ISOs are generally more favorable to employees than nonqualified or nonstatutory stock options (“NQOs,” also called “NSOs”). And the opportunity to immediately exercise the options, receive the shares (subject to vesting), and make an 83(b) election is generally thought to mean the start of the capital gains holding period.

The primary benefit of an ISO is that on exercise, an employee does not have ordinary income when there is a “spread” on exercise (meaning, on exercise the fair market value of the stock exceeds the strike price).

The ISO exclusion from ordinary income tax also extends to employment taxes on the spread. And any spread is also not subject to the new Medicare surtaxes that were part of Obamacare, which impose an additional 3.8% tax on gains from stock that are considered “net investment income” in excess of certain thresholds.

If you are familiar with the math, income and employment taxes on the receipt of illiquid stock of your employer can be a huge financial burden that you may not have the ability to pay. (This is why employees frequently say, in response to an offer from an employer of high-value company stock, “No, I don’t want your stock. I can’t afford it.”) This is why options are so helpful–with an option you can defer the tax until you exercise (an event typically within the optonee’s control).

So, an offer of an immediately exercisable ISO is a reasonable approach to equity compensation, and should be appreciated for its advantages. We’re not here to knock the Silicon Valley way. But there is another fact most people miss.

Immediately Exercisable ISOs: Not Always Ideal

If you plan to exercise your options immediately (that is, immediately upon receipt), you would be better off if the option were an NQO rather than an ISO.

Why? How would an immediately exercisable option be better for you if set up as an NQO than an ISO? Well, like everything with ISO taxation, it’s complicated.

Firstly, it’s worth remembering the well-known “AMT trap,” where you sometimes have to pay taxes at time of exercise anyway, not as ordinary income tax, but in the form of AMT. As a reminder, when you exercise your ISO, even though you will have no ordinary income on exercise, the spread will be considered an AMT adjustment. This AMT tax event can be a big problem, particularly since the private stock probably can’t be sold to pay the possibly large tax bill. During the first dotcom boom, this tax trap drove a number of people into bankruptcy. The problem got so bad Congress passed a one-time forgiveness.

However, the usual AMT trap isn’t an issue for immediately exercisable options granted to new employees, where the strike price and fair market are likely the same—when the employee intends to exercise immediately.

Differing Holding Period Requirements

The issue to worry about here is a second and more subtle factor to do with holding periods to get more favorable long-term capital gains tax rates. The basic holding period requirements for ISOs and NQOs are different:

• ISO: To get long-term capital gains on the exercise of an ISO, you have to hold the shares for two years from the date of grant of the option until sale, and at least one year from the date of exercise until sale. In other words, you have a two-year holding period if you plan to immediately exercise.
• NQO: If you receive an immediately exercisable NQO, and exercise it immediately, you will have no income and employment taxes due because the strike price equals the fair market value. And if you file your 83(b) election, you will then start your capital gains holding period. And on an NQO, you only have to hold the shares for longer than one year to get long term capital gains treatment, not two.

Waiting two years is worse than waiting one. But to make matters worse, there are technicalities about ISOs that can make it even harder to meet the long-term capital gains holding period than the two years you’d expect. Many people believe early exercise together with an 83(b) election will start the clock sooner and help them hold the stock longer, to qualify for long-term capital gains. While this is true for NQOs, it’s not true for ISOs.

The IRS rules on ISOs say that the 83(b) election is valid only for AMT purposes — not for ordinary income tax purposes. What this means is that if you make a disqualifying disposition, then your capital gains holding period for ordinary income tax purposes does not start until the shares actually vest (see Example 2 in Treas. Reg. §1.422-1(b)(3), quoted in its entirety below). If you timely make an 83(b) election on early exercise of an ISO, the election works for ISO and AMT purposes. This means that if there is no disqualifying disposition, and you meet your holding period requirements, and the other ISO qualifications, you start your capital gains holding period on exercise, not on vesting.

So, if you want to immediately exercise an option and file an Section 83(b) election, it’s better if you can have it be an NQO. If you ask your employer to make your option grant an NQO, your employer should be able to accommodate you. And if you’re a founder or CFO, you might want to consider if this is the right choice for early employees in your company.

Some Rules of Thumb

We would offer the following rules of thumb:

• If you can choose between an immediately exercisable ISO and an immediately exercisable NQO, and you plan to exercise right away—you should choose the immediately exercisable NQO.
• If you can choose between an immediately exercisable ISO and an immediately exercisable NQO, and you don’t know if you are going to exercise right away, the question becomes more difficult. In general, in this scenario—choose the ISO.

Below are examples from the Treasury Regulations which show the IRS’s view on immediately exercisable ISOs. The IRS takes the view that since there is no ordinary income on the exercise of ISO, an 83(b) election with respect to an ISO can’t have any effect on the tax outcome, and the election is only effective for AMT purposes.

Of course, it would be nice if Congress fixed this whole mess. Indeed, if Congress really cared to remove perverse penalties from the tax code, it would simply repeal income and employment taxes on the receipt of illiquid stock altogether. It is not as if you can sell the stock to pay the taxes. You can’t do anything with the stock (and if your high-risk startup tanks, it’s ultimately worth little or nothing). In fact, thanks to the securities laws, you have to represent and warrant that you plan to hold the shares “indefinitely” for “investment purposes.” In other words, you pay your taxes… on illiquid shares… that you represent you will hold forever.

But we digress. None of those tax code changes are likely soon. So in the meantime, if you receive an immediately exercisable ISO, and you plan to exercise right away, consider asking that it be an NQO, not an ISO.

Examples from the Treasury Regulations at 1.422-1:

Example 1. Disqualifying disposition of vested stock.

On June 1, 2006, X Corporation grants an incentive stock option to A, an employee of X Corporation, entitling A to purchase one share of X Corporation stock. On August 1, 2006, A exercises the option, and the share of X Corporation stock is transferred to A on that date. The option price is $100 (the fair market value of a share of X Corporation stock on June 1, 2006), and the fair market value of a share of X Corporation stock on August 1, 2006 (the date of transfer) is $200. The share transferred to A is transferable and not subject to a substantial risk of forfeiture. A makes a disqualifying disposition by selling the share on June 1, 2007, for $250. The amount of compensation attributable to A’s exercise is $100 (the difference between the fair market value of the share at the date of transfer, $200, and the amount paid for the share, $100). Because the amount realized ($250) is greater than the value of the share at transfer ($200), paragraph (b)(2)(i) of this section does not apply and thus does not affect the amount includible as compensation in A’s gross income and deductible by X. A must include in gross income for the taxable year in which the sale occurred $100 as compensation and $50 as capital gain ($250, the amount realized from the sale, less A’s basis of $200 (the $100 paid for the share plus the $100 increase in basis resulting from the inclusion of that amount in A’s gross income as compensation attributable to the exercise of the option)). If the requirements of section 83(h) and § 1.83-6(a) are satisfied and the deduction is otherwise allowable under section 162, for its taxable year in which the disqualifying disposition occurs, X Corporation is allowed a deduction of $100 for compensation attributable to A’s exercise of the incentive stock option.

Example 2. Disqualifying disposition of unvested stock.

Assume the same facts as in Example 1, except that the share of X Corporation stock received by A is subject to a substantial risk of forfeiture and not transferable for a period of six months after such exercise. Assume further that the fair market value of X Corporation stock is $225 on February 1, 2007, the date on which the six-month restriction lapses. Because section 83 does not apply for ordinary income tax purposes on the date of exercise, A cannot make an effective section 83(b) election at that time (although such an election is permissible for alternative minimum tax purposes). Additionally, at the time of the disposition, section 422 and § 1.422-1(a) no longer apply, and thus, section 83(a) is used to measure the consequences of the disposition, and the holding period for capital gain purposes begins on the vesting date, six months after exercise. The amount of compensation attributable to A’s exercise of the option and disqualifying disposition of the share is $125 (the difference between the fair market value of the share on the date that the restriction lapsed, $225, and the amount paid for the share, $100). Because the amount realized ($225) is greater than the value of the share at transfer ($200), paragraph (b)(2)(i) of this section does not apply and thus does not affect the amount includible as compensation in A’s gross income and deductible by X. A must include $125 of compensation income and $25 of capital gain in gross income for the taxable year in which the disposition occurs ($250, the amount realized from the sale, less A’s basis of $225 (the $100 paid for the share plus the $125 increase in basis resulting from the inclusion of that amount of compensation in A’s gross income)). If the requirements of section 83(h) and § 1.83-6(a) are satisfied and the deduction is otherwise allowable under section 162, for its taxable year in which the disqualifying disposition occurs, X Corporation is allowed a deduction of $125 for the compensation attributable to A’s exercise of the option.
This blog post does not constitute legal advice or the establishment of an attorney-client relationship. In all instances you should consult your own attorney or tax advisor with respect to the facts of your particular situation.

By Joshua Levy and Joe Wallin

I overreacted a bit in my last blog post when I said that Washington State’s crowdfunding law might be statutorily “broken” if the SEC’s proposed rules on Rule 147 were adopted.

If you are not familiar with how the securities laws in this area are written, Rule 147 is the rule that interprets Section 3(a)(11) of the Securities Act. Almost all state crowdfunding laws that have been enacted have based compliance with their law on compliance with Section 3(a)(11).

Now the SEC has proposed that Rule 147 be removed as a safe harbor from Section 3(a)(11). Rule 147 would disappear and become its own stand-alone exemption. Section 3(a)(11) would not have an underlying set of regulations that interpret it and provide a safe harbor for compliance. This would put companies trying to raise money in a state crowdfunding offering in an tougher spot than they are in right now, because there is very little guidance under Section 3(a)(11), and application of the statute is unclear.

So by removing the Rule 147 safe harbor, the SEC is removing a pillar in the support beams for state crowdfunding.

The SEC is accepting comments on its proposed rules. The SEC in fact suggested something in its proposed rules that made a lot of sense. Here is what the SEC asked:

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?

This is exactly what the SEC should do (as long as moving the new proposed Rule 147 to Rule 505 also doesn’t somehow cause problems with the state crowdfunding statutes).

But the SEC should also take parts of their proposed rules that do not violate Section 3(a)(11), and they should port those into existing Rule 147. For example, proposed Rule 147 has a better, more flexible definition of what constitutes an in-state business.

If you want to know exactly why the SEC’s proposed rules would harm the Washington crowdfunding statute, this is why:

Section 3(a)(11) requires that companies using it:

• be incorporated in the state in which they are conducting the offering; and
• not sell OR offer any securities outside of the state in which the offering is being conducted.

The requirement that you not offer your securities across state lines is difficult. How do you advertise your offering on the Internet if you can’t make the “offer” to anyone outside of your state. The SEC would fix this problem in its proposed rules, and I applaud that. But there is no reason to upset existing Rule 147 to do so.

Dear SEC:

Please leave the existing Rule 147 safe harbor to Section 3(a)(11) in place. Please adopt your proposed rules as the new rule somewhere else that will not harm state crowdfunding statutes.

If you keep existing Rule 147 in place, you will avoid harming state crowdfunding statutes.

You asked in your proposed rules whether the Commission’s process gave states enough time to fix their statutes in light of your proposed rules. It will not. It took two years to pass Washington’s crowdfunding bill. In other states it has taken much longer. In other states people have been trying for years and still not gotten something passed. Sometimes it is not possible to get amendments to securities law statutes through a legislature even after a dozen years of effort.

Please do not upset the currently in place state crowdfunding laws. It would be unfair to the rights of the states to set their own path for the SEC to disrupt the settled expectations of existing Rule 147.

You can still improve Rule 147 at the same time. Loosening up the 80% test is a great idea. That is something that can be changed to existing Rule 147 that will not violate Section 3(a)(11).

Thank you.

Joe Wallin