Discussion of tax related issues for startup companies

1. 1. Choice of entity
2. Qualified Small Business Stock
3. § 305(c) New Proposed Regulations
4. Dynamic Split Models
5. Difference In Taxation For Rights To Acquire Stock
6. Difference In Taxation For Partnership Interests
7. Incorporation of an LLC
8. § 409A And The Deferred Compensation
9. Employee vs. Independent Contractor Issues
Tax Issues for Startup Company

2. • Primary considerations:
 Is the availability to take tax losses critical to the client?
 Are tax-deferred or tax-free fringe benefits important?
 Does the client expect to do a public offering in the future or grow the business to sell it?
 Is the business the type that will expose its owners to great liability?
 Will value be generated in intellectual property?
 Will it be necessary to move assets in and out of the business?
 Will the owners share profits and losses equally? Will special allocations be required?
 Will there be limitations on owner’s ability to transfer their ownership interests in the business?
 Will there be foreign owners?
 Will there be owner-level taxes, such as state income tax, intangible personal property tax, self-employment tax,
etc.?
 Will investors be brought in?
 Who will manage the entity?
1. Choice of Entity

3. Entity Form LLC S Corporation C Corporation Partnership
Entity Level
Federal Income
Taxes
No federal tax at LLC level
unless LLC elects to be
taxed as corporation.
Generally no tax at S
corporation level; some
excise taxes, and built in
gains taxes may apply.
Income tax on
earnings at corporate
level.
No federal tax at
partnership level.
Number of
Required
Owners
Any number. No more than 100. Any number. At least two.
Eligibility
Requirements
of Owners
No restrictions. US citizens or resident
individuals, certain
trusts, and certain tax
exempt entities.
No restrictions. No restrictions.
Entity Level
California Taxes
8.84% corporate rate
applies, or $800 minimum
franchise tax. Gross
receipts fee.
Minimum franchise tax
of $800 or 1.5% taxable
income.
8.84% corporate rate
applies, or $800
minimum franchise
tax.
$800 minimum
franchise tax on
limited partnerships,
no California income
tax on general
partnerships.
Option Plans,
NSO's, ISO's
Employees & consultants
can be given options to
acquire LLC interests, but
such options are generally
more complex. ISO’s not
available.
ISO’s commonly granted
to employees. NSO’s
may be granted to
consultants and
advisors.
ISO’s commonly
granted to employees.
NSO’s may be granted
to consultants and
advisors.
Employees &
consultants can be
given options to
acquire partnership
interests, but such
options are generally
more complex. ISO’s
not available.
1. Choice of Entity

4. Entity Form LLC S Corporation C Corporation Partnership
Status Change on
Transfer of
Interests
LLC terminates for tax
purposes on transfer of 50%
or more of capital and profits
in 12 months.
No termination of entity
on transfer of interests.
No termination of entity
on transfer of interests.
Partnership terminates
for tax purposes on
transfer of 50% or more
of capital and profits in
12 mos.
Treatment of
Foreign Owners
Foreign members subject to
US tax on their share of
effectively connected income
of LLC; branch profits tax may
apply.
Foreigners cannot be
shareholders of S
corporation.
Foreigners are subject
to withholding tax on
dividends from US
corporation, subject to
treaty rate or exemption.
Foreign partners subject
to US tax on their share
of partnership's
effectively connected
income; branch profits
tax may apply.
Foreign
Individual
Owners - Transfer
Taxes
Membership interest may be
subject to US estate and gift
taxes.
N/A. Foreigners cannot
be shareholders of S
corporation.
Corporate stock is not
US situs asset for gift
tax purposes.
Partnership interest may
be subject to US estate
and gift taxes.
Conversion to
Another Entity
May be incorporated tax free. Can convert to C
corporation by revoking
election; may be taxed
on converting to LLC.
Can convert to S
corporation by making
election (built in gains
tax may apply to later
dispositions of
appreciated property).
Conversion to LLC may
be taxable.
Easily converted to LLC
or incorporated tax free.
Taxes on Sale or
Liquidation
One level of tax, generally
capital gain except for amount
allocable to certain assets.
One level of tax on sale
of stock or assets,
generally capital gain on
stock sale.
Potential double tax.
Corporate tax on sale of
assets. Shareholder
level tax on sale of
stock or liquidation.
One level of tax,
generally capital gain
except for amount
allocable to certain
assets.
1. Choice of Entity

5. • S Corporation Eligibility 26 U.S. Code §1361
 Is not an ineligible corporation (as defined in §1361(b)(2));
 Does not have more than 100 shareholders;
 Does not have shareholders other than individuals, estates, certain trusts, and certain tax-exempt
organizations;
 Has no nonresident shareholders; and
 Does not have more than one class of stock.
‒ All outstanding shares must confer identical rights to operating and liquidating distributions. 26 U.S. Code
§1362(d)(2)
‒ Treasury stock and unissued stock of a different class than that held by the shareholders does not
disqualify a corporation. Treas. Reg. §1.1361-1(l)(1); See also PLR 201326012
‒ Differences in voting rights are disregarded in determining whether a corporation has more than one class
of stock. Treas. Reg. §1.1361-1(l)(1)
‒ Call options, warrants, or other arrangements may accidently create a second class of stock if, the
instrument is substantially certain to be exercised by the holder and has a strike price substantially below
the fair market value of the underlying stock on the issuing date, transferred by an eligible shareholder to
a person who is not an eligible shareholder, or materially modified. Treas. Reg. §1.1361-1(l)(4)(iii)(A)
‒ Debt may be recharacterized as a second class of stock, unless certain safe harbor requirements are met
under §1361(c)(5). Treas. Reg. §1.1361-1(l)(4)(ii)
1. Choice of Entity

6. • Primary considerations:
 Do you expect to take money from a VC or an institutional investor.
‒ If yes, you will need to be a C corporation, although you may be able to start life with an S election and only convert if it
becomes necessary.
 Will you be a typical technology company that will want to issue stock options to employees, raise capital through
preferred stock, and expect a typical technology company life-cycle in which all surplus will be reinvested into the
company (no distributions to owners) which is grown until the company is acquired or goes public?
‒ These factors would push you toward the C corporation because LLC and S corporation will add complexity to equity
derivatives (which will be discussed in section 4).
 Alternatively, will your company be operated for its cash flows over a long period of time, not necessarily
managed for a public exit.
‒ In this case, a pass through entity such as an LLC or an S corporation may be preferable.
• Liquidation of S corporations
a. Corporate level
‒ “Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter, subchapter C shall apply
to an S corporation and its shareholders.” 26 U.S. Code § 1371(a)
‒ A corporation will recognize gain or loss on the distribution of property in complete liquidation of the corporation as if the
property were sold at fair market value. 26 U.S. Code § 336
‒ Must recognize built-in gain if S corporation converts in to C corporation. 26 U.S. Code § 1371(a)
b. Shareholder level
‒ Shareholders recognize gain or loss to extent of difference between amount received and their basis in their S corporation
stock. 26 U.S. Code § 331(a)
1. Choice of Entity - Exit Strategy

7. • Liquidation of LLCs and Partnerships
Generally neither the LLC nor the distributee member will recognize gain upon complete liquidation of a limited
liability company (LLC) classified as a partnership. 26 U.S. Code § 731(a)
 Possibility of Gain or Loss Recognition
‒ Gain is recognized by an LLC member on the receipt of a liquidating distribution to the extent money is distributed in excess of
the distributee member's basis in his or her LLC interest. 26 U.S. Code § 731(a)(1)
‒ Gain is recognized when a member receives marketable securities that are treated as money in excess of the member's basis
in his or her LLC interest. 26 U.S. Code § 731(c)(2)
‒ In addition, gain may be recognized if (1) distributions of Sec. 751 hot assets (unrealized receivables and substantially
appreciated inventory) are not proportionate (§ 751(b)); (2) property that had an FMV different from basis on the date of
contribution is distributed to a member other than the contributing member within seven years of contribution
(§704(c)(1)(B)); (3) the distribution is within seven years after a contribution of appreciated property (§737); or (4) the
distribution is part of a disguised sale (§ 707(a)(2)).
‒ A loss may be recognized upon a distribution in liquidation of a member's interest if no property other than cash, unrealized
receivables, and inventory is received. The loss recognized is the excess of the member's adjusted basis in the LLC over the
sum of the cash distributed and the member's basis in the unrealized receivables and inventory received. 26 U.S. Code
§731(a)(2)
 Tax Basis of Property Received
‒ If no gain or loss is recognized on a liquidating distribution, the member's aggregate basis in the property received equals the
member's basis in his or her LLC interest just before the distribution, reduced by the cash and marketable securities
distributed. 26 U.S. Code § 732(b)
 Holding Period for Distributed Assets
‒ A member's holding period for property received in a nontaxable distribution includes the holding period of the LLC. 26 U.S.
Code § 735(b) and § 1223(2)
1. Choice of Entity - Exit Strategy (Continue)

8. • Federal Level- three provisions of the Internal Revenue Code give preferential
treatment to equity investments in small business corporations:
– § 1045: allows the tax-deferred rollover of gain realized on the sale of stock of one
qualified small business corporation into stock of another qualified small business
corporation. Individual must hold QSBS for at least six months.
– § 1202: allows taxpayers other than corporations to exclude from their gross
income:
 50% of the gain realized on the sale of qualified small business stock if the taxpayer holds
the stock for more than five years before the sale;
 75% of the gain if it acquired the qualified small business stock after February 17, 2009
and before September 28, 2010 and held it for more than five years; and
 100% of the gain if it acquired the qualified small business stock after September 27, 2010
and held for more than five years. the PATH Act also permanently extends the rule that
eliminates the 100% excluded QSBS gain as a preference item for Alternative Minimum Tax
(AMT) purposes. In addition, the 100% excluded QSBS gain is not subject to 3.8% Net
Investment Income Tax.
– § 1244: allows taxpayers to claim an ordinary (rather than a capital) loss on the
disposition of qualifying small business stock. Moreover, any loss that qualifies as an
ordinary loss under § 1244 is also treated as a trade or business loss in computing
an individual’s net operating loss (NOL).
2. Qualified Small Business Stock- Federal

9. • State Level – California
– California does not follow federal income tax treatment of QSBS
under § 1202.
– According to the Assembly Bill No. 1412, California does not allow
any QSBS gain exclusion for stock sales made on or after January 1,
2013. For QSBS sales made before January 1, 2013, California
allows exclusion of 50% of gain from disposition of QSBS, but
requires:
 When the stock was issued, at least 80 percent of the
corporation’s payroll was attributable to employment located
within California for QSBS sales made in taxable years after
December 31, 2007, and before January 1, 2013.
– AMT tax preference: California picks up one-half of the gain
exclusion (i.e. 25 percent of total gain from disposition of QSBS) as
a tax preference item.
2. Qualified Small Business Stock- State

10. Background
• The general rule is that a stock distribution is not taxable subject to
various exceptions. 26 U.S. Code § 305(a)
• Under § 305(c), convertible Instruments (such as prefer stocks,
warrants, rights or convertible debts) holders may be deemed to
receive a stock distribution upon the occurrence of a conversion rate
adjustment (a “CRA”) that increase holders’ proportionate interest in
the earnings and profits or assets of the issuer, and the deemed
distribution may be characterized as a taxable stock distribution if it
was a “disproportionate distribution”.
– However, “an applicable adjustment made pursuant to a bona fide, reasonable
adjustment formula that has the effect of preventing dilution of a shareholder’s
interest is not a deemed distribution of stock to which Sections 305(b) and 301
apply.” Treas. Reg. § 1.305-7(b)(1).
3. § 305 (C) New Proposed Regulations

11. Proposed Regulations:
• IRS issued proposed regulations (REG-133673-15*) interpreting
deemed distributions under § 305(c).
– Timing: the deemed distribution occurs contemporaneously to the
applicable adjustment, but in no event later than the date of the
property distribution giving rise to the deemed distribution.
– Amount: the amount of the deemed distribution is equal to the
increase in the fair market value of the right embodied in the
convertible instrument resulting from the adjustment.
– Withholding requirement: withholding agents are required to
withhold tax on deemed distributions to foreign holders even if
there is no actual cash payment made to the holders.
3. § 305 (C ) Proposed Regulations (Continue)
* REG–133673–15, available at https://www.irs.gov/irb/2016-18_IRB/ar11.html

12. • FOUNDER’S EQUITY
4. Dynamic Split Models

13. 4. Dynamic Split Models

14. Grunt Fund
Source: http://www.slicingpie.com/the-grunt-fund-calculator/

15. Grunt Fund Detail
Source: http://www.slicingpie.com/the-grunt-fund-calculator/

16. 5. Equity Derivatives – Convertible Debt
*See Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders ¶4.40 (7th ed. 2000)
 Convertible debt issued as an Investment
‒ Tax treatment: treated like any other debt instrument until conversion, if*:
a. The exercise price is significantly higher than the issuer's current stock price, so conversion is not highly likely
b. Holder is entitled to receive the full principal amount of the debt
c. A market rate of interest (allowing for the fact that the conversion feature will significantly reduce interest rate)
d. A holder has the right to sue for payment of the debt in the event of default.
‒ Original Issue Discount
a. Holder: includes stated interest and original issue discount (OID) as it economically accrues in income. 26 U.S. Code § 1272 (a)
b. Issuer: generally may deduct accrued interest and OID until conversion. 26 U.S. Code § 163(e)(1) and (2)
‒ Tax Consequences of Conversion
a. Conversion is a non-taxable event, and the holder's basis in the convertible debt becomes the holder's basis in the stock. Treas.
Reg. 1.1001-3(c)(2)(ii)
b. The holding period of the stock will include the holding period of the debt instrument (at least with respect to the original
issue price) 26 U.S. Code § 1223 (1)
 Debt v. Equity
‒ The tax law has a long and tortured history of delineating “debt” from “equity”. Therefore, great care must be
exercised when structuring a convertible debt instrument, in order to ensure that it will be classified as debt.
‒ IRS has issued several rulings in which it sets forth its views on the proper debt/equity characterization of various
convertible instruments. For example, when the likelihood that a convertible instrument will be exercised is so
high that the instrument itself is treated as equity (not debt) for tax purposes. Rev. Rul. 82-150, 1982-2 C.B. 110;
Rev. Rul. 83-98

17. 5. Equity Derivatives – Warrants
• Investment warrants
– Part of an Investment Unit
When a warrant is received in conjunction with a debt instrument, the amount paid for that investment unit must be allocated
between the warrant and the debt instrument based on their relative fair market values. 26 U.S. Code § 1273(d)(2) The
allocation usually will generate OID on the debt instrument.
– Tax Treatment
a. No gain or loss upon exercise. The purchase price of the warrant is capitalized and is included in the adjusted tax basis of the
stock purchased buy the exercise of the warrant.
b. If the holder does not exercise the warrant, for tax purpose will treat like the holder had sold it for nothing on the expiration
date of the warrant. 26 U.S. Code § 1234(a)(2); Treas. Reg. § 1.1234-1(b); Rev. Rul. 78-182, 1978-1 C.B. 265
c. The issuing company recognize no gain or loss when the warrant is exercised, or lapsed.
– Tacking
a. The holding period of the stock purchased by the exercise of a warrant begins on the day that the warrant is exercised, not
when the warrant was acquired. 26 U.S. Code § 1223(5); Treas. Reg. § 1.1223-1(f)
b. If the warrants are exchanged for stock (other than NQPS) in a recapitalization or other reorganization under § 368, then
the holding periods of the warrants tacks on to the holding period of the stock acquired (because warrants are treated as
“securities” under § 354. See Treas. Dec. 8752, reprinted in 1998-1 C.B. 611; 26 U.S. Code § 354(a)(2); 26 U.S. Code §
1223(1)
– Treated as stock under § 305(d)
Warrants, convertible debts and other rights to acquire stock of a corporation are treated as “stock” under for the
purpose of determine whether certain distributions by the company to its shareholders of additional interests in the
corporation’s assets are to be taxed as dividends. Treas. Reg. § 1.305-3(b)(5)

18. 5. Equity Derivatives – Incentive Stock Options
• Qualifications of ISO
– For a stock option to qualify as an ISO, the option and the optionee must meet certain requirements when it is granted and certain
requirements during the period the option is held by the optionee until the option is exercised. Treas. Regs. §1.422-2(a)(1), (a)(2);
Trea. Regs. §1.422-1.
• Tax treatment
 Grant of ISO
‒ No taxable income to employee; No deduction to employer. Treas. Regs. §1.83-3(a)(2); 26 U.S. Code § 421(a)(2)
 Exercise of ISO
‒ No income to employee; No deduction to employer. 26 U.S. Code § 422(a) ; § 421(a)(2)
‒ Tax basis in the stock received equals to the amount paid by the employee to exercise the ISO. 26 U.S. Code § 421(a)(3)
‒ The exercise of an ISO will not be subject to income tax withholding or to employment taxes. Treas. Regs. §1.421-2(a)(1)(i)
 Transfer, Cancellation or Lapse of ISO
‒ An ISO, by its terms, cannot be transferable except upon the death of an employee. 26 U.S. Code § 422(b)(5)
‒ If an employer cancels an ISO in exchange for a cash payment or transfer of other consideration to an employee, the employee
will recognize ordinary income in an amount equal to the value of the consideration. PLR 7809072; Bagley v. Comr., 85 T.C. 663
(1985)
‒ Employer is required to withholding income tax and employment taxes. Rev. Rul. 67-366, 1967-2 C.B. 165.
‒ Employee cannot recognize loss if an ISO lapses at the end of its term or otherwise without having been exercised, even if the
ISO stock's fair market value exceeds the ISO exercise price at the time of the lapse. 26 U.S. Code § 1234(a)(2)
 Disqualifying Disposition of ISO Stock
‒ Employee generally recognizes long term capital gain upon subsequent disposition of the ISO stock. 26 U.S. Code § 1222(3)
‒ Disqualifying dispositions: If the stock is sold within: a) 2 years after the ISO is granted, or b) 1 year after the ISO is exercised, 26 U.S. Code §
422(a)(1)
a. the employee will recognize as ordinary income the difference between the ISO's exercise price and the ISO stock's fair market value at the time of
option exercise (the “bargain purchase element”). Treas. Regs. §1.421-2(b)(1)
b. Such ordinary income will be added to the ISO stock's basis to determine the capital gain that must be recognized on the disqualifying disposition.
Treas. Regs. §1.421-2(a)(2)

19. 5. Equity Derivatives – ISO (Continue)
• Modification, Extension or Renewal of ISOs
‒ In general, the modification, extension or renewal of an ISO will be considered the grant of a new option. 26 U.S. Code §424(h)(1); Treas.
Regs. §1.424-1(e)(2)
‒ To qualify as an ISO, this new option must have an exercise price that is no lower than the FMV of the stock subject to the option at the
time of the modification, extension or renewal, and it must meet all additional requirements that apply to ISOs generally. 26 U.S. Code
§424(h)(1)
‒ If an ISO is amended such that, as amended, it fails to meet all of the requirements for ISO treatment, it will be treated as an NSO
following such amendment. Treas. Regs. §1.424-1(e)(5)
• Alternative Minimum Tax Considerations
Although the exercise of an ISO does not result in current taxable income, there are implications with regard to the alternative minimum
tax (AMT). When calculating income for AMT purposes, the favorable tax treatment of §421(a) is disregarded, and the bargain purchase
element of the ISO will be considered a preference adjustment (i.e., as part of alternative minimum taxable income (AMTI)) for the year in
which the option is exercised. 26 U.S. Code § 56(b)(3)
• Golden Parachute Tax Considerations
‒ The grant of an ISO or the vesting of an ISO, as applicable, may be subject to §280G and §4999, even though neither the grant nor the
vesting of the ISO would be includible in gross income under §61(a). Treas. Regs. §1.280G-1
‒ §280G denies an employer a deduction for certain payments to certain individuals that are contingent on a change in control of the
employer if those payments are “excess parachute payments.” In addition, §4999 imposes a 20% excise tax on the recipient of an
“excess parachute payment.” Treas. Regs. §1.280G-1

20. 5. Equity Derivatives – Employee Stock Purchase Plans
• Qualifications of ESPP
‒ ESPP must meet the requirements set forth in §423(b) to receive favorable tax treatment available under §421(a).
‒ The major distinction between ESPP and ISO is that ESPP can offer purchase rights with a purchase price as low as the lesser of 85% of the fair
market value of the stock at the time of grant or 85% of the fair market value of the stock at the time of purchase. 26 U.S. Code §423(b)(6); Treas.
Regs. §1.423-2(g)(1)
• Tax treatment
 Grant/Exercise of Purchase Right
No income tax to an employee upon the grant of a purchase right under a §423 plan or upon the exercise of such right. 26 U.S. Code §421(a)(1)
 Terminate of Employment
If the employee terminates his or her employment with the employer more than three months before the exercise of the purchase right, the
employee will recognize as ordinary income the excess of the fair market value of the stock on the date of exercise over the purchase price.
26 U.S. Code §423(a)
 Disposition of Acquired Stock
a. Qualifying Disposition 26 U.S. Code §423(c)
‒ Sell the stock after the expiration of the statutory holding period, or in the event of the employee's death;
‒ Employee will recognize ordinary income equal to the lesser of:
(1) the excess of the fair market of the stock on the date of grant of the purchase right over the exercise price of the purchase right, and
(2) the excess of the amount realized on the disposition of the stock over the exercise price of the purchase right.
‒ Any additional gain or loss recognized on the disposition of the stock will be long-term capital gain or loss. Disqualifying Disposition
b. Disqualifying disposition Treas. Regs. §1.421-2(b)(1)
‒ Sells or otherwise disposes of stock before the expiration of the statutory holding period
‒ Employee is required to recognize ordinary income equal to the excess of the fair market value of the stock on the date of exercise of the
purchase right over the exercise price.
‒ Any additional gain or loss recognized on the disposition of the stock will be short-term or long-term capital gain or loss, depending on
the length of time the employee holds the stock after exercise of the purchase right.
• Alternative Minimum Tax Considerations
‒ No issue with AMT when an employee buy shares under an ESPP.

21. 5. Equity Derivatives – Nonqualified Employee Options
• Character of Income and Timing of Income
‒ Holder: Ordinary income upon exercise (if the option does not have a readily ascertainable fair market value at the time of grant) or
grant (if the option has a readily ascertainable fair market value at the time of grant)plus capital gain upon sale. 26 U.S. Code §83(e)(3),
(4).
‒ Issuer: Issuer can deduct amount equal to amount that option holder recognizes as income in the same year. 26 U.S. Code §83(h); Treas.
Regs. §1.83-6(a)
• Basis and Holding Period
a. Option taxed at grant
‒ The employee takes the property acquired upon the exercise of the option with a basis equal to the amount paid upon the exercise of the
option, plus any basis that the employee had in the option itself (amount taxed at grant plus any amount paid for the option). Rev. Rul. 78-
182; Treas. Reg. §1.61-2(d)(2)(i)
‒ The holding period of the property acquired begins only with the day after the option exercise. No tacking of holding periods occurs from
the holding period of the option. See Helvering v. San Joaquin Fruit & Inv. Co., 297 U.S. 496 (1936)
b. Option taxes at exercise
‒ The employee takes a basis equal to the sum of the property's cost (i.e., the exercise price) and the option's basis in the hands of the option
holder. See Rev. Rul. 78-182, 1978-1 C.B. 265 (Ruling A, 4)
‒ The holding period begins on the day on which the property is acquired. No tacking of holding periods. 26 U.S. Code §83(f)
• Disposition and Cancellation of Option
a. Option taxed at grant
If the underlying property would have been a capital asset to the holder, any gain or loss arising from the disposition of the option
will be capital in nature. The capital gain or loss will be short-term or long-term, depending upon the option holder's holding period
in the option. Rev. Rul. 78-182, 1978-1 C.B. 265 (Ruling A, 2)
b. Option taxes at exercise
‒ In an arm's-length disposition, employee recognizes ordinary income to the extent of the difference between the amount realized from the
option's sale and the employee's basis in the option. No other tax consequences to the employee from subsequent events (i.e., when the
arm's-length transferee exercises the option).
Treas. Reg. §1.83-7(a)
‒ In a non-arm's-length disposition, employee may realize compensation income not only at the time of the disposition, but also when the
non-arm's-length transferee exercises the option. Treas. Regs. §1.83-1(c); See also PLRs 199952012, 9421013.

22. 5. Equity Derivatives – NQSO (Continue)
• Lapse of Option
a. Option taxed at grant
‒ Deemed to be a sale or exchange of the option for zero on the day the option expires. 26 U.S. Code §1234(a)(2); Rev.
Rul. 78-182, 1978-1 C.B. 265 (Ruling A, 3)
‒ The employee can recognize loss to the extent of the employee's basis in the option at the time of lapse. 26 U.S. Code
§165(c)(2); §165(f); §1211(b)
b. Option taxes at exercise
Normally no loss arises because of the lack of basis. Treas. Regs. §1.165-1(c)(1)
• Section 83(b) Election
‒ §83(b) election allows employees to limit their ordinary income from the transaction to any difference on the date the property is transferred
between the fair market value and the amount paid for the property. Any appreciation in the property after the date of transfer is converted into
potential capital gain income, which would be recognized only when the employee disposes of the property. 26 U.S. Code §83(b)(1); Treas. Regs.
§1.83-2(a)
‒ The §83(b) election must be made within 30 days after the transfer of the property. 26 U.S. Code §83(b)(2)
‒ The election is irrevocable, unless the IRS agrees to the revocation. 26 U.S. Code §83(b)(2); Treas. Regs. §1.83-2(f)
• Section 409(A) Considerations
‒ Nonqualified employee options can be granted with an exercise price that is lower than the fair market value of the stock at the date of grant
(“Discount Option”). However, such discount option (unless fall into the short-term deferral exemption) generally constitutes “nonqualified
deferred compensation” subject to § 409A, and would be immediately taxable on vesting and subject to an additional 20% penalty tax in addition
to employee's ordinary income tax plus interest. 26 U.S. Code §409(A); §4999
‒ To be exempted under 409A, Company must either conduct or rely on a recently conducted valuation in accordance with Section 409A.

23. 5. Equity Derivatives
• Other types of equity compensation
 Restricted stock
Refers to unregistered shares of ownership in a corporation that are issued to corporate affiliates such as executives and directors.
Restricted stock is nontransferable and must be traded in compliance with special SEC regulations.
‒ Holder can elect to recognize ordinary income on the grant date under § 83(b).
‒ Without the election, the holder is taxed when the shares vest.
 Restricted stock units (RSUs)
A form of stock-based compensation under which an employee is awarded the right to receive a fixed payment equal to the value of a
specified number of shares of employer stock.
‒ RSUs is taxed in a similar manner to the taxation of restricted stock. There is generally neither taxation at grant, nor at vesting, unless no substantial risk of
forfeiture.
‒ Any subsequent gain or loss upon the sale of shares subject to the RSUs will be taxable as short- or long-term capital gain, depending on how long the stock has
been retained.
 Stock appreciation rights (SARs).
SAR provides employee the right to monetary equivalent of the increase in the value of a specified number of shares from the date of
grant through the date of payment.
‒ Not subject to taxation until exercised, provided that both the: 1) the exercise price of the SAR is not less than the fair market value of the underlying stock on
the grant date; and 2)the SAR does not include any additional deferral features.
‒ SARs that meet the requirements are exempt from IRC Section 409A.
 Phantom stock
A form of stock-based compensation under which an employee is awarded the right to receive a fixed payment equal to the value of a
specified number of shares of employer stock. Payment can be made in shares or cash for phantom stock plans.
‒ Phantom stock is generally taxed when the right to the benefit is exercised.
‒ The amount that is taxed is equal to the value of the award minus any consideration paid for it.

24. • Non-compensatory Partnership Option (NCPO) Regulations (T.D. 9612)
– Applicability: Option issued by a partnership other than an option issued in connection with the performance of
services. For this purpose, the term “option” is defined as any call option, warrant, or the conversion feature of
convertible equity or debt. Treas. Reg. §1.761-3(b)(2); §1.761-3(b)(3)
• Tax implications:
 Issuance of NCPO: Generally a non recognition events for both the partnership and the NCPO holder, unless the NCPO holder
transfers appreciated or depreciated property to the partnership in exchange for the NCPO. Treas. Reg. §1.721-2(b)
 Lapse or repurchase of an NCPO: The lapse of an NCPO generally results in recognition of ordinary income by the partnership and
loss by the holder of the lapsed option. 26 U.S. Code §1234(a); §1234(b)
 Exercise of an NCPO: Generally a non recognition events for both the partnership and the NCPO holder. Upon the exercise of an
NCPO, the NCPO holder is viewed as contributing property in the form of the option premium, the exercise price, and the option
privilege to the partnership in exchange for the partnership interest. The partnership revalues its property immediately after the
exercise of the option and allocates the unrealized income, gain, or loss in partnership property from the revaluation to the NCPO
holder until the NCPO holder’s capital account equals the value of his partnership interest. Thus, if there is not sufficient unrealized
appreciation to allocate to the NCPO holder, the conversion will be partially taxable. Treas. Reg. §1.721-2(a)
 Characterization rule: If on the date of certain measurement events, 1) an NCPO provides the holder with rights substantially
similar to the rights afforded to a partner; and 2) at the time of measurement, there is a strong likelihood that the failure to treat
the holder of the NCPO as a partner would result in a substantial reduction in the present value of the partners’ and the holder’s
aggregate tax liabilities, then the holder should be treated as a partner and the option should be taken into account in allocating
partnership income. Treas. Reg. §1.761-3(q)(4)
6. Taxation for Partnership Interests

25. • Investment Warrants on Partnership Interests (Regular and in Penny
Variety) Treas. Reg. §1.761-3(a)(2)
– Under Non-compensatory Partnership Option (NCPO) Regulations, nominally priced
investment warrants will be treated as equity for federal tax purposes if both (i) the
investment warrant provides for rights that are similar to an owner of the
underlying security and (ii) there is a strong likelihood that the failure to treat the
investment warrant holder as the owner would result in a substantial reduction in
the present value of the aggregate tax liabilities of the investment warrant holder
and the owners.
– Penny warrants raise a significant risk that the warrants will be treated as equity.
• Convertible debt as investment Treas. Reg. §1.721-2(a)(2)
– Under Non-compensatory Partnership Option (NCPO) Regulations, In order to
prevent the conversion of ordinary income into capital gain, the general non-
recognition rule upon exercise does not apply to the transfer of a partnership
interest to a non-compensatory partnership option holder in satisfaction of the
partnership’s debt for unpaid interest (including accrued original issue discount) on
convertible debt that accrued on or after the beginning of the convertible debt
holder’s holding period for the debt.
6. Taxation for partnership interests (Continue)

26. • Compensatory Options
The Treasury Department published proposed treasury regulations governing the issuance and vesting of partnership
interests issued in connection with the performance of services in 2005. (Notice 2005-43) The Proposed Regulations
do not specifically include compensatory partnership options in the section 83 definition of “property”, but includes
compensatory partnership interests in the section 83 definition of “property”.
 Capital interests
A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold
at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This
determination generally is made at the time of receipt of the partnership interest. Rev. Proc. 93-27
a. Vested Capital Interest
‒ A capital interest is unrestricted (that is, fully vested) if the interest is transferable free of the substantial risk of forfeiture or is not subject to a
substantial risk of forfeiture.
‒ An employee who receives a vested or unrestricted capital interest in a partnership entity in exchange for the performance of services generally
recognizes compensation income in the year of the grant equal to the fair market value of the interest, reduced by the amount, if any, that the
employee pays for the interest.
‒ The partnership itself generally will be entitled to a deduction equal to the amount of ordinary income recognized by the employee.
b. Unvested Capital Interest
‒ Generally, an employee is not taxed on the receipt of a restricted interest in property until the restriction lapses.
‒ Employee can make §83(b) Election to accelerate the time of taxation of restricted property to the date of its receipt
6. Taxation for partnership interests (Continue)

27. • Compensatory Options
 Profits Interests /Carried interests
A “profits interest” (also referred to as a “carried interest”) is generally a right to receive a percentage of profits from a partnership
without any obligation to contribute capital to the partnership and is awarded to the general partner, investment manager, or other
service provider to the partnership.
– The Diamond Case (1971) In certain circumstances, a profits interest is taxable upon receipt. This ruling offers the notion that
there could be double taxation to a profits interest partner. First taxed on the issuance of the profits interest, then second on
the subsequent allocation of gain by the partnership to the profits interest holder.
– The Campbell Case (1971) The Eighth Circuit in Campbell held that the issuance of a profits interest did not generate taxable
income in the year it was issued because the profits interest had no fair market value at the time it was issued to Campbell.
– Rev. Proc. 93-27, the receipt of a profits interest is generally not a taxable event for the partner or the partnership. Instead,
taxes are imposed as allocations of taxable income are made in respect of the profits interest or on the sale of the interest.
The revenue procedure uses a hypothetical distribution model to determine whether an interest is a profits or capital
interest. Under this model, a member has a capital interest if he or she has a share of unrealized appreciation in the LLC’s
assets at the time of receipt of the interest.
– Notice 2005-43, in a further attempt to clarify the issue of the taxation of a profits interest, the Service has proposed a
procedure in Notice 2005-43 to apply the rules of Code §83 to all transfers of partnership interests for services, without
making any distinction between capital interests and profits interests. Under the proposed Treasury Regulations, if a
partnership interest is transferred to a service provider in connection with his or her performance of services, such interest is
treated as “property” for purposes of Code §83 and could result in ordinary income to the recipient either upon vesting or
upon a Code §83(b) election. Notice 2005-43 contains a safe harbor under which the fair market value of the profits interest
is equal to the liquidation value of that interest at its issuance. If the profits interest is not entitled to any liquidation value,
then no income is recognized to the profits interest recipient upon its issuance.
6. Taxation for partnership interests (Continue)

28. • Start-ups start as LLCs may want to or need to convert into a corporate form at a
later point because:
 Venture capital investors more comfortable with corporate form
 Potential IPO
 Availability of Section 368 reorganization on exit (need to wait two years)
 Incentive Stock Options
 General increased liquidity
 Qualified Small Business Stock exemption
‒ Issuance of stock in a C corporation on incorporation of an LLC may qualify as QSBS stock
‒ Stock held in C Corp following termination of S Corp election does not qualify because stock was not issued in a qualifying
corporation
• Methods of incorporation: The IRS has approved three methods of incorporation
Rev. Rul. 84-111
1. Assets Over
2. Assets Up
3. Interests Over
7. Incorporation of an LLC

29. • Method 1: Assets Over. Old LLC transfers all its assets and liabilities to the
newly formed Newco in exchange for the stock in the Newco first, and then
distributes Newco stock to LLC Members in liquidation.
 Assume transfer satisfies Section 351.
 Old LLC defers tax by taking a carryover basis and holding period in the stock (adjusted for liabilities
assumed by Newco).
 Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain
recognized by Old LLC).
 LLC Members take a substituted basis in the stock equal to their basis in the membership interests
(adjusted for liabilities assumed by Newco and any gain or loss recognized in the transaction) but will
take a carryover holding period in the stock.
7. Incorporation of an LLC (Continue)

30. • Method 2: Assets up. Old LLC transfers all its assets and liabilities to LLC
Members in liquidation first, and then LLC Members contribute assets and
liabilities of Old LLC to Newco in exchange for Newco Stock.
 Assume transfer satisfies Section 351.
 LLC Members take a substituted basis in the assets equal to their basis in the membership interests
(adjusted for any gain or loss recognized in the transaction) but will take carryover cost recovery and
holding periods in the assets.
 LLC Members take a carryover basis and holding period in the stock (adjusted for liabilities assumed by
Newco and any gain or loss recognized in the transaction).
 Newco takes substituted basis in the assets equal to the LLC Members’ bases in their membership
interests (adjusted for any gain or loss recognized in the transaction) but will take a carryover holding
period and cost recovery in the assets.
7. Incorporation of an LLC (Continue)

31. • Method 3: Interests over. LLC Members transfer their Old LLC interests to
Newco in exchange for Newco Stock first, and then Old LLC liquidates, but
treated as asset transfer to Newco.
 Assume transfer satisfies Section 351.
 LLC Members take a substituted basis in the Newco Stock equal to their basis in the membership
interests (adjusted for any gain or loss recognized in the transaction and liabilities assumed by Newco)
and will tack the holding periods of their membership interests to the holding period in Newco Stock.
 Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain
recognized by LLC Members).
7. Incorporation of an LLC (Continue)

32. • Tax concerns:
7. Incorporation of an LLC (Continue)

33. • Common Compensation Related Pitfalls:
 Salary deferral: deferring funders’ wages until the company is funded.
 Misclassification: e.g., misclassifying service providers as “consultants” and
only issue them options, while promising to pay them salaries after the
company is funded.
 Premature Option Grants: granting options to service providers before
they start working.
 Post-Termination Option Acceleration: accelerating option post-
termination of the employee.
 Missing 83(b) Election Deadline: Applicable to equity granted subject to
vesting. Making a 83(b) election allows holders to start the one year
capital gain holding period for their stocks earlier.
‒ Filing must be made within 30 days after the grant date.
8. §409A and Deferred Compensation

34. • Applicability: Section 409A is applicable to broadly defined “nonqualified deferred compensation”, which
allows IRS to immediately tax compensation for service that will be paid in a later year if it violates 409A
requirements. 26 U.S. Code §409A(a)(1)(A).
 Applies to both private and public companies and to all service providers.
 Common compensation arrangements that may be subject to 409A includes:
‒ Traditional deferred compensation /or non-qualified retirement benefits
‒ Severance and separation programs
‒ Phantom stock awards vesting and payments terms
• Major Restrictions under 409(A):
‒ Deferred compensation may only be paid on the occurrence of an event specified when the deferred
compensation is created, and only if the event is on the approved list contained in the statute;
‒ Deferred compensation payments may not be accelerated;
‒ Elections to defer compensation must be made irrevocably in the year before the related services are
rendered, except for: 1) new plan participants; 2) “performance-based compensation”; and 3) “13 month
rule”; and
‒ Various techniques to secure the payment of nonqualified deferred compensation are not permitted.
8. §409A and Deferred Compensation (Continue)

35. • Two-aspect Requirements:
– Documentary compliance: the “nonqualified deferred compensation” plan must not have provisions that
are inconsistent with Section 409A; and
– Action compliance: the action taken concerning the payment of deferred compensation must be consistent
with Section 409A. 26 U.S. Code 409A(d)(1)
• §409A Penalty
– Service provider is required to include the deferred compensation in income and pay 20%
additional tax plus interest in the year when violation occurs. 26 U.S. Code 409A(b)(5)(A)(ii)
• §409A Exemptions
– A qualified employer plan, and
 E.g. tax-qualified retirement plans; ISOs and ESPPs, non qualified stock options with an exercise price
at least equal to fair market and meet certain other requirement, etc. Treas. Regs. §1.409A-1(a)(2)
 Short-term deferral exemption: amount that must be paid in full within 2 and ½ months after the
later of service provider or service recipient's tax year in which the right to the amount becomes non-
forfeitable. Treas. Regs. §1.409A-1(b)(4)(i)
‒ Any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit
plan. Treas. Regs. §1.409A-1(a)(5)
8. §409A and Deferred Compensation (Continue)

36. • International Issues
– §409A affects U.S. citizens and permanent residents working outside of the U.S., as well as U.S.
residents.
– Outbound taxable employees: §409A would apply to a foreign plan on the same basis as a
domestic plan unless the plan meets the definition of a broad-based foreign retirement plan or
the plan benefits are excludible by the service provider based on a tax treaty. See IRS Notice 2005-1
– Inbound taxable employees: §409A would apply if they are considered to be permanent U.S. tax
residents, with the exception that they would be entitled to exclude amounts hypothetically
earned under Sec. 409A before becoming a U.S. tax resident under the regulations or the
provisions of a U.S. bilateral tax treaty, or both.
– Exemption for certain deferred compensation arrangements:
Certain foreign plans can be exempted based on treaties or on the terms and provisions of the
plans. Treas. Regs. §1.409A-1(a)(3)
Certain foreign plans can be exempted based on the nature of the compensation that is paid to
or derived from the foreign plan. Treas. Regs. §1.409A-1(b)(8)
 Income that would have been excludible under Sec. 893 for employees of foreign governments
or certain other international organizations. IRS Notice 2005-1
Income that would have been excluded under Secs. 931 or 933, which apply to income from
Guam, American Samoa, the Northern Mariana Islands. IRS Notice 2005-1
8. §409A and Deferred Compensation (Continue)

37. • For tax purpose, It is critical that the company correctly determines whether individuals
providing services to the business are employees or independent contractors.
‒ Business prefer independent contractors to avoid paying Social Security, Medicare taxes, and
unemployment taxes and to avoid providing health insurance coverage.
‒ Employers run the risk of improperly characterizing independent contractors. IRS is paying more
attention to misclassification issues.
‒ Companies like Uber and Lyft that treat workers as independent contractors are under scrutiny. If the
employer has significant control over the worker, the IRS may claim the worker should have been
classified as an employee.
• Companies must give their workers IRS Form W-2 setting forth their compensation for the
year, and Form 1099 to independent contractors, by February 1st of each year.
• The IRS gives some guidance in IRS Publication 15-A and Form SS-8. The Employment
Development Department provides different factors to determine an employment
relationship.
9. Employee vs. Independent Contractor Issues