The Startup Law Blog

I have heard this a number of times in regards to S Corporations & Blank Check Preferred Stock:

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

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

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

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

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

But what counts as “stock” for this purpose?

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

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

There is also this from the regulations:

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

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

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

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

 

By Jordan Taylor, CPA and Joe Wallin

 

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.

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

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

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

How do RSUs work?

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

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

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

The Tax Problems

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

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

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

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

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

What is the taxation of warrants?

What is a Warrant Anyway?

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

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

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

The Taxation of the Investment Warrant

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

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

The Taxation of the Compensatory Warrant

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

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

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

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

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

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

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

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

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

By Dan Wright of Clark Nuber and Joe Wallin

Dan Wright and Joe Wallin

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

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

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

The Trouble with Crowdfunding

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

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

The IRS Information Letter

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

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

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

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

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

General Tax Principles Apply

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

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

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

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

Request a Ruling?

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

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

Stock option plan administration requires regular attention to compliance obligations.

Events to Watch Out For

There is work to do when:

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

The Importance of Doing This Right

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

Order of Optionee Paperwork

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

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

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

• Review the proposed list of optionees. Do you have any optionees located in states in which you might need to make a filing with the securities regulator in order to grant options in that state? Each state’s laws are different. Some states require filings and the payment of fees to grant options to an optionee resident in that state (e.g., California); other states have self-executing exemptions provided your plan is administered in accordance with federal Rule 701. Because each state is different, you need to be careful whenever granting options to any optionee located outside of your home state (where you presumably have already done the compliance work to grant options to optionees living in that state). We maintain a 50 state guide to assist in this process.
• Do you have enough shares authorized and available for use in your plan? Increases in plan share reserves or the adoption of a new plan will likely involve stockholder approval as well as board approval.
• Confirm your Plan is not more than 10 years old and has expired.
• Make sure you are updating your stock ledger (cap table).
• Make sure each optionee execute the company’s form of stock option agreement, and that you deliver a copy of the stock option plan to each optionee.
• Do the proposed stock option grants cause you to run over Rule 701’s mathematical limitations? Remember, Rule 701 has absolute mathematical limitations that you cannot go over. There are three different measurements, and you only have to comply with one of them, but companies can easily surpass the limits if they are not paying attention to this issue.
• Do the proposed stock option grants cause you to have granted more than $10M in equity awards in the last 12 months, which would require you to prepare and deliver a prospectus to optionees? A prospectus must contain certain enhanced disclosures, risk factors, and financial statements. In July 2018, the SEC amended the dollar threshold in Rule 701(e) for this prospective requirement from $5M to $10M, reasoning that the additional disclosures make it more expensive for companies to compensate their employees and that raising the threshold to $10M will alleviate those concerns.
• Have you determined the current fair market value of the stock? Are the options being granted at no less than that fair market value? Has there been a material event since the company’s last 409A valuation?
• Are you in the 409A waiting period, when you cannot grant options until the 409A valuation is complete? This delay can occur when your 409A valuation report is in process and you don’t know the current fair market value of the stock.

What To Do For Each Exercise of Stock Options

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

What To Do When People Leave

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

End of Year Tax Compliance Dates

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

It is well known that a company has to withhold income and employment taxes from an employee exercising nonqualified stock options.

What About Former Employees?

What is less well known is, what do you do if this person has left the employment of the company? What if they left employment years ago and are not even in the payroll system anymore?

This is becoming more common because companies are starting to extend exercise windows, sometimes for years. You can find a list of the companies that have extended the post-termination exercise periods under their stock option plans to something beyond the traditional 90-day window https://github.com/holman/extended-exercise-windows.

So, What Do You Do?

So, what do you do when a former employee shows up to exercise a stock option that was granted to the person in connection with their employment? Do you withhold? Do you put them back in the payroll system? Or do you simply just issue the Form 1099?

The answer is — it doesn’t matter if an employee left employment years ago. It doesn’t matter if the employee is no longer in your payroll system. If the option was granted in the context of employment, then you have to withhold income and employment tax withholding, even if the option is no longer an employee at the time of exercise. The character of the payment is wages.

KPMG wrote a helpful guide on this point, which says:

“The taxable spread on the exercise of an NSO by an employee (or at vesting if the stock received on exercise remains subject to an SROF) is considered wages subject to employment tax withholding and must be reported by the employer on Form W-2, Wage, and Tax Statement. The employment tax withholding and Form W- 2 reporting requirements continue to apply on exercise of an NSO even when the employee option-holder terminates employment with the company prior to exercise of the option.”

https://home.kpmg.com/content/dam/kpmg/pdf/2015/09/tnf-stock-option-sep8-2015.pdf

The Treasury Regulations on point—26 CFR 31.3121(a)-1(i)—state as follows:

“Remuneration for employment, unless such remuneration is specifically excepted under section 3121(a) or paragraph (j) of this section, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them.”

It is important to get this right because if you do not withhold the income and employment taxes from the employee, the company can become liable for those amounts to the IRS.

Nonqualified Stock Options is written by The Startup Blog. For related articles, please click here.

By Nikki Piplani and Joe Wallin

If you are a startup company founder, one of the first questions you will have will be about sharing equity with your early hires. Once you start asking, you will hear plenty of advice about this.

You will hear— “Be generous”. You will also hear— “Worry about dilution”. The concerns around dilution are fair, but you do need to form a team, and if you are a very early stage startup, your most powerful incentive, aside from an interesting problem to solve, is a generous equity offer.

Immediately after the issuance of the founders’ shares, the general consensus seems to be to reserve between 15- 30% of the issued and outstanding shares in a stock incentive plan for your key hires. (Meaning, if you have issued 4M shares to your founders you would set aside about 600,000 shares in the stock option or stock incentive pool.)

But beyond reserving some amount of shares in a stock incentive plan, there are still plenty of questions to work through.

“Is there a right or suggested amount of equity for the positions startups typically want to fill?”

“Is there a published schedule somewhere, where I can read about what to give out in equity to my early hires, and that shows how this changes as my startup matures? Sort of like what you see on the Founder’s Institute Fast Form site for advisory board members?”

“Or is hiring and sharing equity something that varies so much depending on the particular facts that no industry standards or guidelines exist?”

And then, “Once I find out the number of shares to give someone, from a legal and tax point of view, what do I need to think about?”

And finally, “How do I document this all correctly so as to not step off some unknown legal or tax ledge where I hurt myself, my company, or the person I was trying to incentive with the equity award in the first place?”

Based on our experience navigating these questions, we’ve put together a brief guide for helping you think through the process.

How Many Shares?

Unfortunately, determining exactly how much equity to grant to your early team is not easy. There are no scheduled or published guidelines. It is all very fact specific.

As Sam Altman said in a recent blog post, “It’s very difficult to put precise numbers on this because the specifics of every situation matter so much.” http://blog.samaltman.com/employee-equity . Information is scattered and may be hard to find, but there is some data out there on how many shares to issue to members of the team. Quora.com and blogs like AVC.com are good places to start. Again, Sam Altman’s recent blog post is helpful. Here is what Sam says:

“I think a company ought to be giving at least 10% in total to the first 10 employees, 5% to the next 20, and 5% to the next 50.”

And then, of course, there is this post from Guy Kawasaki. And here is another article with data as well.

Calculating the Actual Number of Shares

A lot of people get confused on this point. Truth is, there are a lot of different ways to take a given percentage and translate it into an actual number of shares. For instance, you can calculate the number of shares based on:

• The corporation’s issued shares outstanding shares
• The corporation’s issued and outstanding shares plus the number of shares already covered by stock options that have been granted
• The corporation’s issued and outstanding plus the corporation’s entire stock option or stock incentive pool

(By the way, you never translate a percentage interest into a number of shares based on the corporation’s authorized shares; that number is made up. What matters are how many shares are actually issued.)

What if your company has already issued a Series Seed or Series A? Do you count those toward the percentage?

The most important thing to do in translating a percentage into an actual number of shares is to do it in a way that can be easily and transparently described by you to your new hires.

Here is how you do this calculation:

A percentage is translated into a number of shares based on the issued and outstanding shares (not authorized!), on a fully diluted basis, but not taking into account convertible debt and convertible equity that will convert to shares on the closing of the next round.

The fully diluted share count includes:

• All issued and outstanding common shares;
• All issued and outstanding preferred shares;
• All of the shares in the equity plan; and
• Sometimes the shares underlying any outstanding warrants (this depends on the characteristics of the warrants; whether they are warrants to purchase shares on the next financing whose share impact can’t yet be calculated or whether their dilutive impact is already understood and baked into the cap table ).

Convertible notes or convertible equity that are waiting to convert to shares on the next fixed price round are usually left out. The reason? It is hard to know how many shares will be issued for these instruments. Plus, the award recipients and the founders will equally be diluted in the next round. It makes sense that your award recipients would incur the same dilution on the next financing as the founders.

Another reason to include the entire pool (rather than just the number of shares that are covered by currently issued awards under the plan) is for ease of calculation.

(For another reference on this point, see this article by Matthew Bartus : https://www.cooleygo.com/option-grants-fully-diluted-issued-outstanding/)

Let’s say you’ve settled on a 2% option grant for a new hire. How do you translate that 2% into an actual number of shares?

Your corporation will probably have a pretty big number of “authorized” shares. For example, you might have 20M total shares authorized. But, you might have only issued your founders 4M in total, and set aside in an option plan 600,000 shares. In this example then, your fully diluted share number would be 4.6M. How do you calculate 2% in this scenario?

You calculate the 2% based on the issued and oustanding common plus the entire pool. So you multiply 2% times 4.6M.

The main reasons to include the entire pool (rather than just the number of shares that are covered by awards under the plan) are: (i) ease of calculation, (ii) for the sake of consistency – this is how percentages of start-ups are typically calculated (e.g., this is how an angel or VC investor does this calculation), and (iii) this way the next person you grant options to you can use the same method of calculation and 2% in the next grant will result in the same number of shares.

Of course, if your new team members have questions on how you calculated the number of shares, tell them how you did it. Forthrightness in this area is important.

Your new team members might ask—”But won’t I be diluted in the future?” And the answer is— “Yes, all of us will.” This is the way it is in startup land.

What Type of Award?

Once you have decided on how much equity to give to someone, the next question is—what type of award should you give this person? There are really on a couple of choices in startup land:

• Stock Options; and
• Restricted Stock Awards

Bigger companies sometimes use RSUs. A good example of this is a company like Twitter, when it was ramping up to its IPO. It was using RSUs by this time. There comes a time in a startup’s life when RSUs start to maybe make sense, but not at the outset of the company’s life. At the outset, the way to go is either stock options or restricted stock awards.

Restricted stock awards, however, are really only helpful when the value of the company is really, really low. Like right at the start of a company. The reason? Taxes. Once a company’s value has become say, a quarter of a million dollars or more, award recipients either won’t be able to afford or not want to pay the income and employment taxes on stock awards.

For example, say you want to give an early developer 5%. If your company is worth $250,000, 5% of $250,000 is $12,500. This is $12,500 of taxable income. The taxes, counting employment taxes, will be several thousand dollars. Many people would rather not come out of pocket several thousand dollars to receive an illiquid stock award.

When this happens, you will then have moved into the zone where stock options are the only type of equity award that makes sense for the time being.

The Two Types of Stock Options

There are two types of stock options:

• nonqualified or nonstatutory stock options (NQOs); and
• statutory or incentive stock options (ISOs).

Only employees can receive ISOs. So independent contractors and directors who are not employees must receive NQOs.

ISOs can be more valuable to employees. But ISOs are more complex than NQOs to explain and administer. The exercise of ISOs can give rise to complex Alternative Minimum Tax consequences. Plus the company loses a tax deduction on an ISO. These are all reasons to keep your life simple and just grant NQOs across the board.

How to Document the Offer in an Offer Letter

This is another place where companies make mistakes.

Your offer letter should always say the equity grant is subject to board approval. This is not only a good practice but a requirement because an equity award is not legally granted unless the board approves. It is also smart because what if the board doesn’t approve? Or what if your optionees suddenly quits the company under unfriendly or hostile circumstances?

Example offer letter languge:

“Subject to the approval of the Company’s Board of Directors, you will be granted an option to purchase _____ shares of Company common stock under the Company’s stock option plan at an exercise price equal to the fair market value of that stock on your option grant date. Your option will vest over a period of four years, and will be subject to the terms and conditions of the Company’s stock option plan and standard form of stock option agreement, which you will be required to sign as a condition of receiving the option.”

In the offer letter, do not refer to a percentage. You have to specify the actual number of shares covered by the award.

Once you offer someone a percentage you have entered into the unknown. As explained above, there are many different ways to translate a percentage interest into an actual number of shares. You don’t want a dispute over that. Put in a hard number. You can explain to the optionee the summary cap table so that they can understand how the percentage interest can be calculated.

Is there a checklist of all the paperwork required?

Yes.

Prior to Granting Stock Options or Restricted Stock Awards:

First, work with a lawyer to prepare a plan and the standard award agreements under the plan. Work with your lawyer to make sure that the board and shareholders adopt the plan in accordance with state corporate law. If shareholders do not approve the plan, you cannot grant ISOs, and you may be required to make additional, special filings with state securities regulators.

Grant all of your awards under the plan-If you are granting awards outside of your plan, you may not have a securities law exemption for the issuance of the award. This is the kind of mistake that can cost a lot of money to fix later. So, make sure you comply with the law in this area. There is a reason everyone adopts a plan and grants awards under the plan. The reason is that the path to compliance with the securities laws is easier and much less expensive with a board and shareholder approved plan than with other alternatives.

Make sure all of your awards are approved in unanimously executed Board Consents or appropriately documented in minutes of correctly noticed and called board meetings at which a quorum of directors was present. Again, work with your lawyer to make sure this is done right. If you do not do this right fixing it can be extremely expensive.

Confirm that you have sufficient shares in your plan to cover the award – Prior to granting awards, confirm you have the number of shares under the plan to grant the new batch of awards.

Rule 701- Before every grant of awards, 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 these limits, see Rule 701: https://thestartuplawblog.com/rule-701/

Prospectus– If you have granted more than $5M in awards during the last 12 months, make sure to provide the prospectus required by Rule 701.

Eligible recipients– Confirm each prospective award 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 award recipients and confirm that you are compliant with the Blue Sky law of each state in which the award recipients are resident.

If you are granting options to optionees in California, special attention will need to be given to California’s requirements. In California you have to file a form and pay a fee to grant stock options. The same goes for New York State, where you actually have to apply to the Attorney General for an exemption to grant stock options.

Fair market value- Make sure that 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 an award, give each recipient a copy of the plan and their award agreements, and have them sign the agreements required under the plan.

Capitalization ledger– Update the capitalization ledger once the option is approved.

In Summary

There are guidelines in this area, but this is also a complex area of your startup. With equity compensation you hit all the hard issues:

• How much equity will you share to incentivize key hires;
• How will you explain it to them so that they understand it and fully appreciate the incentive (after all, how much is an incentive worth if not understood?)
• And then of course there are all of the legal and tax complexities on top of that.

To make things easier on yourself, It makes sense to follow industry standard practices as much as possible. And don’t try to tackle this one without a lawyer. The legal details are really important in this area, so make sure you get good advice. Good luck!

In startup land, aside from cash compensation, stock options are the most important part of employee compensation. (This is the case because once a startup is beyond the very early, initial startup phase, no other form of equity compensation–such as restricted stock or RSUs–works very well from a tax point of view for employees.)

Because equity compensation is such an important part of your overall employee compensation, it is important to maximize the benefit of your stock option plan to your employees.

How do you do this? Well, probably the most important thing to do is clearly communicate with your employees on the type of options they are receiving, what their options entitle them to, and how they work.

Employees frequently have a lots of questions about their options, including questions on how they work, and the tax consequences to them of receiving and ultimately exercising the options.

There are only two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQOs).

You will have to choose what type of options to grant.

ISOs have certain special tax advantages to employees over NQOs, but those employee advantages come at a cost (and potentially a significant one) to the company.

What Are the Advantages to the Employee of an ISO?

• No ordinary income tax on exercise
• No employment tax on exercise
• If two holding periods are met, long term capital gain on sale
• If the holding periods are not met, if there was spread on exercise, you will have ordinary income equal to that amount on sale of the stock, and if there is gain beyond that, short term capital gain on that portion, but still no employment tax withholding.

Nonqualified stock options trigger income and employment tax withholding on exercise, if there is a spread on exercise. This is arguably a benefit of an NQO over an ISO because it is easier to calculate the income and employment taxes on an NQO exercise than the Alternative Minimum Tax (“AMT”) consequences of an ISO exercise.

The Costs to the Employer of an ISO

• The loss of the deduction of the spread on exercise.
• In contrast, with a nonqualified stock option, the company gets to deduct the spread on the exercise of an NQO. This can be a significant tax benefit to a profitable company.

The Qualifications and Limitations

If you decide you want to grant ISOs, you will need to know the various qualifications and limitations of ISOs.

Again, these qualifications and limitations are in exchange for the special tax advantages an ISO provides to employees over nonqualified stock options.

The ISO qualifications and limitations are:

• ISOs can only be granted to employees. So independent contractors and members of the board of directors who aren’t otherwise employees can’t receive ISOs.
• Only the first $100,000 that becomes exercisable during any 12 month period can qualify for ISO treatment.
• ISOs to 10% or greater stockholders have to be priced at 110% of FMV and have no more than 5 year term.
• The spread on the exercise of an ISO is not subject to ordinary income tax and employment tax withholding but the spread on exercise is an AMT adjustment.
• The spread on the exercise of an ISO is not deductible to the company.
• ISOs have to be granted pursuant to a plan that specifies the aggregated number of shares that may be issued under options and the employees or class of employees eligible to receive options, and which is approved by the shareholders within 12 months before or after the date the plan is adopted.
• ISOs have to be granted within 10 years from the date the plan plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier.
• ISOs cannot be exercisable after the expiration of 10 years from the date such option is granted.
• ISOs have to be granted with an option price not less than the fair market value of the stock at the time such option is granted.
• ISOs cannot by their terms be transferable otherwise than by will or the laws of descent and distribution, and may be exercisable, during the optionee’s lifetime, only by the optionee.

The Full Benefit of ISOs is Rarely Realized

Probably the most important thing to know about ISOs is that most of the time the primary benefits of an ISO are not realized by the employee. Most employees don’t exercise their options until and in connection with a liquidity event—at which time they will not have satisfied the two holding periods. Nevertheless, even in that context, there are employment tax savings (although these might be relativity small, they still exist).

This blog does not constitute legal or tax advice.

If you are not familiar, last December the Congress and the President made permanent one of the most significant tax breaks probably ever made available to founders and investors in startups. They created something that they could have rightfully called, “Tax Free Startup Company Stock.”

What am I talking about?

Well, last December the Congress and the President made permanent the 100% exclusion from tax on gain from the sale of qualified small business stock held for more than 5 years. Since September 27, 2010, when the 100% exclusion first went into effect at President Obama’s urging, it had always been set to expire every 6-12 months. Now it is here to stay.

This means that if you found a startup company, or you buy stock in a startup company, and that startup company is a C corporation engaged in a “qualified trade or business” (see definition quoted below) with less than $50 million in gross assets (both before and after you and others invest), you can completely avoid tax on up to $10M in gain on the sale of that company’s stock.

This doesn’t work if you form your new business as a LLC taxed as a partnership or an S corporation.

Section 1202 is a big deal, and one that you ought to carefully consider when selecting an entity form for your business, or what types of businesses to invest in.

But, as you might imagine, Section 1202 does have a number of limitations and qualifications.

I received a question about some of those limitations this morning.

The Question Went Like This:

Joe, I thought I remembered a $1 million limitation on how much 1202 stock a company could issue in a given year but looking through your blog and a number of other sources it seems I’m confusing 1202 with some other tax benefit. Does this ring a bell? Is there a limit (other than the gross assets, active business and use of proceeds tests) I need to think about?

The Answer To This Queston Is:

There is no limit on how much 1202 stock a company can issue in a given year, except for the $50M gross assets limitation you mention above.

Section 1202(d) defines the term “qualified small business” as any domestic corporation which is a C corporation if:

“(A) the aggregate gross assets of such corporation (or any predecessor thereof) at all times on or after the date of the enactment of the Revenue Reconciliation Act of 1993 and before the issuance did not exceed $50,000,000,
(B) the aggregate gross assets of such corporation immediately after the issuance (determined by taking into account amounts received in the issuance) do not exceed $50,000,000, and
(C) such corporation agrees to submit such reports to the Secretary and to shareholders as the Secretary may require to carry out the purposes of this section.”

Thus, while there is no express limitation on how many shares a company can issue that qualify as Section 1202 “qualified small business stock,” (see definition below) once the company has in excess of $50M in gross assets, it cannot issue qualified small business stock at all.

If you are recalling a $1 million limit of some kind, you are probably thinking of Section 1244. Section 1244 allows an ordinary as opposed to a capital loss on an investment in a C corporation, if you are one of the first $1 million invested.

Section 1244 is about losses. Section 1202 is about gains.

Section 1202 is a significant tax benefit to consider as you plan how to start and invest in companies.

*********Definitions below

“Qualified small business stock” means any stock in a C corporation which is originally issued after the date of the enactment of the Revenue Reconciliation Act of 1993, if—
(A) as of the date of issuance, such corporation is a qualified small business, and
(B) except as provided in subsections (f) and (h), such stock is acquired by the taxpayer at its original issue (directly or through an underwriter)—
(i) in exchange for money or other property (not including stock), or
(ii) as compensation for services provided to such corporation (other than services performed as an underwriter of such stock).

“Qualified trade or business” means any trade or business other than—
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, daccounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.

By Ashley Long

If you are a startup company, your brand (your trademarks) may be one of your most important items of intellectual property. Protecting your brand through one or more federally registered trademarks is usually a really smart move. For not very much money, you can obtain federal rights allowing you to stop subsequent users from adopting your brand. If you simply use your brand, you obtain common law rights to it–but these common law rights provide limited protections.

A related question, once you have filed for your U.S. trademarks, is whether to file for protection outside the U.S.

When To File For Trademarks Outside the U.S.

If your brand is going reach beyond the U.S., and if you plan to expand your business operations abroad, then it is a good to at least consider foreign trademark filings.

Trademark rights are granted on a country-by-country basis.  As such, your use or registration of a trademark in the U.S. won’t give you trademark protection beyond our borders.

Let’s start with how the U.S. is different from other countries.  In the U.S., just using a brand in commerce will grant you some legal rights over the brand.  Many jurisdictions, however, are “first-to-file” countries.  That means whoever registers a trademark first – regardless of whether they’re using it – is the owner of the mark.  For example, both China and Japan are “first-to-file” countries.

Filing in all of the countries around the world can be an imposing proposition – both logistically and economically.  Here are some things to consider before commencing any foreign filings:

• Will my brand have any presence in that country/region?
• Am I willing to enforce my trademark rights if something goes wrong there?
• Are the jurisdictions first-to-file or first-to-use countries?

If you’ve recently filed a trademark application in the U.S., you have a little breathing room before making any foreign filing decisions.  As long as you proceed with your foreign filings within 6 months of your U.S. filing date, your trademark rights in the foreign jurisdictions will be retroactive to the U.S. filing date.  This is important because it means that, even if a conflicting trademark was filed before yours, you are still first in line if your U.S. date predates the other filing.  (You can file after the 6 month priority deadline, you just won’t have the benefit of the U.S. filing date.)

Questions about foreign filings?  Please feel free to contact us for more information!