NY Startup Law

A businesslaw blog for New York entrepreneurs by Marc Law Associates PLLC

THE STARTUP EMPLOYEE GUIDE TO PROTECTING RESTRICTED STOCK

In the early stages of your startup, you’re going to want to build the best team available, but many of you won’t have money to pay your team members what they’re worth, or anything for that matter. You’re going to have to sell the shit out of your vision and the ability to execute it to entice anyone worth having on your team to work for peanuts. A good engineer, if you can find one, should cost you between and in annual salary. An outside CEO? Fugghedaboutit. Even if you can convince a few capable people that you have the next Facebook, you’re still going to have to pay them or offer them in some form of sweat equity. Sweat equity comes in a few forms, but this article will focus on restricted stock.
WHAT IS RESTRICTED STOCK?
Restricted stock is common stock you will usually issue to early employees or consultants as a means of keeping them on your team for a set time period, and holding them to their promise by giving out the stock in equal increments during a pre-determined time period, commonly referred to as a vesting schedule. A vesting schedule puts the Restricted in the term restricted stock. The stock will “vest” after a negotiated “trigger” or condition. If the trigger never happens, the SP never receives the stock. The SP remaining with the company for a certain amount of time is one example of a trigger. Another could be that the stock vests when the company gets acquired. Pretty simple, right? Another common restriction on restricted stock is to whom or how the SP is allowed to sell the stock once it vests. The startup will usually retain the right of first refusal, which means that the SP would have to offer the startup the opportunity to purchase the stock before allowing the SP to sell or transfer it to anyone else. For example, if you issue 400 shares of restricted stock to your first CTO subject to a 4 year vesting schedule, with a one year cliff, you will issue the CTO 100 shares on an annual basis, first shares after year one from the date in your restricted stock agreement (“RSA”). Even though you’re not paying him cash up-front, and all you’re doing is handing the CTO an agreement, the IRS still considers this paper transfer employee wages, which require you to withhold taxes at a maximum rate of 39.1 percent.
VALUATION OF THE STOCK TRANSFER AND TAXATION UNDER 83(a)
Section 83(a) of the tax code prescribes that the transfer of restricted stock is equal to the fair market value of the shares on the grant date AND the right to any appreciation thereafter. The most important thing for your company to worry about is who it’s going to use to determine the fair market value of the shares. Even if you consider yourself a mathematical and economical genius, don’t do this yourself. Hire a reputable third party to perform if for you. Doing it yourself will subject you to more scrutiny from the IRS, and allowing a company or professional increases the likelihood that the valuation is accurate, and gives you someone to blame if it isn’t. There are niche companies and CPA firms that you can hire to determine the right valuation, one that will pass IRS scrutiny.
Under Section 83(a) each transfer during the vesting schedule is taxable as compensation income under the maximum tax rate at the previously mentioned 39.1 % tax rate. The startup is responsible for withholding those taxes at each transfer interval and the service provider is responsible for paying those taxes. If the value of the company increases during the time period between the grant date and the vested transfer, so too will the tax obligation of the service provider. Where will the money come from to pay those taxes if you’re not paying the employee? The employee will have to set aside money, or you can loan them the money to pay the taxes. The loan however, has to be legitimized by the execution of a contract, most likely a promissory note with real terms and conditions to pass IRS scrutiny. Notice the theme here? In order to receive the benefits associated with restricted stock, and any sweat equity vehicle, strict recognition of and adherence to the IRS Code is a must.
TAXATION UNDER SECTION 83(b)
The method of maximizing the value of restricted stock from the employee or service provider perspective lies within Section 83(b) of the tax code. Properly filing an election to have your restricted stock treated under the code accomplishes two main things.
• It locks the valuation of the shares as the fair market value on the grant date throughout the entire vesting period, which can be a huge benefit if the stock appreciates in value, which is presumably the reason you’ll be able to convince a rockstar to take a chance on your company without getting paid what they’re worth.

• The actual transfers during the vesting schedule and/or the exit are taxed as long term capital gains which max out at 20%, instead of the 39.1 federal income tax rate associated with salaried compensation. In order to receive this preferred tax rate, the SP has to hold on to the stock for at least one year after the vesting period.
This can provide a huge potential savings to the startup employee or consultant if done correctly. The first thing an SP will want to assess is whether the company is one that will grow in value. This strategy is worthless if it isn’t. From the company perspective, offering restricted stock makes the most sense at the infancy of the startup’s life cycle. The first thing the SP should worry about is the strict time limit for making an 83(b) election. It’s 30 days. Not 31, not 35, not 30 days and 20 minutes. Failure to adhere to the time limit can be catastrophic. The SP would lose all of the beneficial tax treatment of the appreciated value as long term capital gains should the value increase, and the SP will have to have to come up with money to pay compensation taxes in accordance with the appreciation of the stock during each vesting interval instead of being taxed upfront at a lower valuation. I advise startups not to promise to make the election for the SP. Put the onus on the SP to avoid a lawsuit by the SP for failure to file on time. What the startup can do though, is provide the SP with a FAQ or fact sheet instructing the SP on the importance of filing the 83b election.

 

PatrickMarc Esq.

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