The Startup Law Blog

Congress is trying to make life easier for early stage and startup companies. This is good.

But so far, nothing has been proposed to fix Section 83(b) of the Internal Revenue Code.

Section 83(b) haunts every founder who receives shares subject to vesting.

If you are founding an early stage technology company with other founders, you will probably impose vesting on all of the shares issued to the founders. Vesting in this context means the following: if you quit providing services, the company has the right to buy back your “unvested” shares. The purchase price is the lesser of either (i) the FMV of the shares at the time of repurchase, or (ii) the price you paid for them (usually this is not a big number). This lower-of-fmv-or-cost repurchase right lapses over the vesting period, usually 4 years with a cliff of some kind.

Vesting is critical to include in company formation documents. If a 30% founder leaves, your company will essentially be un-fundable if a 30% owner is no longer working at the company.

But the current tax law does not make life easy for founders in this circumstance.

The Current Tax Law

The current tax law requires founders to file an 83(b) within 30 days of receiving their shares or suffer horrible, potentially debilitating tax consequences.

If you file the election, you typically won’t owe any tax as a result of filing. And your filing the form timely means that you won’t owe any tax when your shares vest.

If you don’t file the election, you will owe tax when your shares vest if the shares have gone up in value. The tax you owe will be based on the difference between the fair market value of the shares at the time of vesting over what you paid for them. If you are an employee, you will have to write a check to the company so that the company can send the funds to the IRS to pay the employee’s side of income and employment tax withholding. This can get expensive fast.

The tax code should not be written like it is now. We shouldn’t put founders on a 30 day ticking time bomb whenever they found a company. This is hostile to people founding companies.

Instead, we should reverse the presumption in Section 83(b). What I mean is that an 83(b) election is “deemed filed” if the Founder would not owe any tax as a result of filing it.

This would allow founders to sleep at night, and making forming and starting companies easier. Isn’t that what we want Congress?

I drafted proposed legislation along these lines a few years back. You can find it here.

If you happen to run into legislators or legislative staff working on federal tax issues, please mention this idea to them.

Congress is preparing a bill known as the Financial CHOICE Act of 2016. There is a lot in the bill (and so it is worth scanning the table of contents for issues you might care about). One of the provisions of the bill, Section 1066, would revise the Form D filing requirements to make them easier on companies in general, including startups.

For the sake of clarity, Section 1066 makes it clear that the SEC is not to condition the availability of the exemption under Rule 506 on the filing of the form. This is good, but it leaves a gap in the law.

Many states require issuers to file the Form D in their state if the company is either resident there or has investors resident there. This means that even if the Congress clarifies that a federal Form D filing is not required, companies will still have to file and file with sometimes a variety of states. Many states impose substantial filings fees (e.g., $525 in Pennsylvania). Other states impose late filing fees (e.g., New Mexico).

Let’s fix 1066 to fix the state problem.

Let’s expressly add to Section 1066 that no state securities law administrator or authority can condition the availability the exemption on the Form D filing as well.

If you know anyone who is working on this bill, please suggest this to them. I am going to try as well.

I testified yesterday before the Washington State House of Representatives Business & Financial Services Committee regarding the state’s Equity Crowdfunding law, and presented a list of recommendations for how to improve the regulations and make the law a more effective fundraising tool.

Raising money is a hard job for startups. It is made harder because there is a lack of angel and venture capital financing in Seattle and around Washington, especially relative to the level top tech talent we have here. I believe Washington’s Equity Crowdfunding law could become an important mechanism to fill this fundraising gap for startups by opening up the investment ecosystem to small investors. If implemented effectively, crowdfunding could be an alternative source of capital that will incentivize entrepreneurs to take risks needed to create successful, local businesses and will become an engine for job growth.

To date, however, there isn’t a single Washington company that has raised money under this law, and only two have even had their application approved by the state’s Department of Financial Institutions (“DFI”). By contrast, under Oregon’s equity crowdfunding law, Oregon companies have raised $450,000. While there are some important differences (a maximum rise of $250,000 in Oregon vs. $1M in Washington), Oregon has much fewer onerous regulations. We should push to amend and repeal some of DFI’s regulations. I recommend:

1. Don’t require public disclosure of executive officer and director compensation. Disclosure to shareholders is sufficient.
2. Allow for convertible debt or straight debt, including revenue loans. Currently, only equity is allowed. The most common way startups raise their initial funding round is through convertible notes.
3. Don’t require review and approval by DFI, especially for smaller offerings (i.e., up to $250,000, like Oregon). This could lead to a more flexible two-tiered crowdfunding regulatory scheme with other lighter-weight requirements.
4. Don’t require escrow, especially for smaller offerings. It’s just another costly barrier.
5. Allow “accredited investors” to invest an unlimited amount. There’s no reason to cap them at $100,000.
6. Amend our laws to be harmonized with the SEC’s new regulations, particularly Rule 147A, which allows for crowdfunded offerings to be advertised on the internet and social media so long as securities are only issued to intrastate investors.
7. Allow online portals to earn a success fee (say 3-5%) upon closing a crowdfunded round without having to be a registered broker-dealer.
8. Allow entities to invest in crowdfunded offerings.
9. Allow the law to be used for real estate investments.
10. Repeal DFI’s rule specifying the preferences that preferred stock must-have. Such preferences are not market.

If these improvements are made, more Washington businesses will be able to get off the ground and prevent entrepreneurs from fleeing to the Bay Area or elsewhere in search of capital. It will also attract other companies to move here as we continue to develop a more robust startup landscape.

The Business & Financial Services Committee seemed genuinely engaged and receptive to making at least some of these improvements during yesterday’s hearing. The DFI also signaled its agreement with us that the law should address debt offerings and that the state should harmonize the rules to fall in line with the SEC’s recent amendments. I am hopeful that the legislature and the DFI will be able to implement these recommended improvements in the near future.

By Daniel Neuman.  I am a corporate and securities lawyer, working primarily with startups and early-stage companies in Seattle.

If you want to read more articles about equity crowdfunding, please visit our website, here.

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, professionals, entrepreneurs, educators, closely-held or family businesses, franchises, Fortune 500 corporations, and insurance companies.  They are in the private sector, public sector, and governments.  Our clients are forward thinkers, creative, collaborative, and deliver high-quality products and business services to their markets.  Their markets extend into almost every industry including, food and beverage, retail, professional services, arts, health care, education, manufacturing, technology, construction, real estate, and more.  We advocate for our clients.  We strategize with them to meet their goals.

The first bill out of the new Congress next year might set the accredited investor definition to adjust with inflation. As the bill is currently drafted, every 5 years the financial thresholds would go up based on inflation.

The bill is called the Financial Choice Act. You can find it here.

I think this is a bad idea for the following reasons:

• The inflation adjustments will slowly disqualify angels who meet the current standards, reducing the number of angel investors available to invest in early stage startup companies.
• If inflation adjustments had been in place when the current financial thresholds had been adopted, we would have 1/3rd fewer angel investors than we do today.
• Already, outside of Silicon Valley, finding angel investors to invest in companies is extremely difficult.
• This automatic inflation adjustment will hurt middle America worse. It is harder to meet the income tests in middle America. In middle America, we ought to adjust the thresholds down to take into account regional variations in income.
• Along the lines of the last point, check out this great article by Leslie Jump. She makes what I think is a great point. We need to facilitate getting angel and venture capital investment dollars into areas that have been traditionally under-served by those sources of capital.
• As stated in the Comprehensive Summary of the Financial Choice Act:

“Private placement offerings are a key source of equity capital for many small and emerging companies that generate a disproportionate share of the new jobs in our economy. Because such offerings are generally available only to accredited and other sophisticated investors, it is essential that the SEC not overly restrict the pool of accredited investors.”

Oddly enough, the Comprehensive Summary of the bill doesn’t mention indexing.

• Even though inflation has been relatively tame, it might ramp up at any time. The President-elect’s big infrastructure plans could heat up inflation, for example.

If you can think of any other reasons why you think indexing these standards to inflation is a bad idea, please share them. Let’s press this case. I think the early stage ecosystem will be harmed by indexing. Thank you.

Indexing the Accredited Investor Standard to Inflation: A Bad Idea

Now that the election is over, it is unclear, at least to me, which direction startup public policy will take. It is in all of our best interests that we have a startup public policy that promotes innovation and creativity. Too often we have laws that slow us down, impede us, or flat out make it illegal, whatever new product or innovation it is we are working on.

It appears that one of the first acts of Congress is going to be the Financial Choice Act. There are provisions of this act that will affect the startup ecosystem. We should make our voices heard if we care about this.

Section 452 of the Financial Choice Act would do the following:

• Repeal Section 413 of Dodd-Frank. The primary effect of this would be to take out of the SEC’s hands the review and modification of the accredited investor standards. Section 413 also requires the SEC to review and issue a report on the definition every 4 years. You can read the first report here. This would apparently go away with the repeal of section 413 as well. I agree in general that the SEC should not be able to make the definition of accredited investor worse, but it ought to be able to make it better (meaning, bringing more people into the definition, perhaps, for example, by imposing investment limitations on individuals that do not meet the current financial thresholders). I liked the SEC’s first report on the matter. It had some good ideas. Such as allowing Indian tribes to qualify as accredited investors (by a weird quirk of the way the current SEC rules are written, Indian tribes do not qualify as accredited investors, even if they have tens of millions of dollars in assets and investments).
• Codify the financial thresholds to qualify as an accredited investor. I would also view this as a positive.
• Set the financial thresholds to qualify to automatically adjust with inflation. I view this as a negative.
• Create two new categories of accredited investor:
  • anyone who is currently licensed or registered as a broker or investment advisor by the SEC, FINRA, or an equivalent SRO, or the securities division of a state or equivalent state division responsible for licensing or registration of individuals in connection with securities activities; and
  • anyone the SEC determines, by regulation, to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA or an equivalent SRO.

Both of the latter two ideas are good ideas. But as far as testing in, I am not sure FINRA is the right entity to administer such a test. Wouldn’t it be great if individual state securities administrators could administer such a test? The young MBA grad, for example, who doesn’t have $1M in net worth, but is young and has a long investment time horizon, seems to me ought be allowed to test in.

Indexing is a Bad Idea for Standard Inflation

I know different people have different thoughts on this. But I personally think indexing the financial thresholds to adjust with inflation is a bad idea. Sure, inflation has been low for years. But for all we know we will go through a period again, in the not too far future, where we have significant inflation. If we do, then this law will start automatically defining people out of the category of accredited investor. I think it would be more logical to leave the current numbers in place, and if Congress decides to change them in the future, Congress can change them.

To put it in context, one of the early versions of Dodd-Frank would have adjusted the financial thresholds to inflation, going all the way back to when they were set. We estimated that 2/3rds of all angel investors in America would no longer have qualified as accredited investors.

If Congress wants to index something to inflation that will improve the business regulation environment, it ought to index the $600 1099 threshold to inflation. That number hasn’t changed in forever. If it had been set to adjust to inflation, it would be something on the order of $5,000 right now.

If you want to read more related articles on standard inflation, please visit our website, here.

If you have any questions about this article or standard inflation, please reach out to me, here.

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, professionals, entrepreneurs, educators, closely-held or family businesses, franchises, Fortune 500 corporations, and insurance companies.  They are in the private sector, public sector, and governments.  Our clients are forward thinkers, creative, collaborative, and deliver high-quality products and business services to their markets.  Their markets extend into almost every industry including, food and beverage, retail, professional services, arts, health care, education, manufacturing, technology, construction, real estate, and more.  We advocate for our clients.  We strategize with them to meet their goals.

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

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’s press release
• 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.

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:

• Proposed Rules
• Comments

For more related articles, please visit our website, here.

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, professionals, entrepreneurs, educators, closely-held or family businesses, franchises, Fortune 500 corporations, and insurance companies.  They are in the private sector, public sector, and governments.  Our clients are forward thinkers, creative, collaborative, and deliver high-quality products and business services to their markets.  Their markets extend into almost every industry including, food and beverage, retail, professional services, arts, health care, education, manufacturing, technology, construction, real estate, and more.  We advocate for our clients.  We strategize with them to meet their goals.

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 significant. If you setting up a brand new startup in the typical way, with founders paying par value per share, the exclusion will be up to $10M for qualified small business stock held for more than 5 years.

The exclusion can be larger than $10M if you are incorporating a company with assets that have a significant fair market value.

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.

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.

Question:

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!

Answer:

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.

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.