Section 83(a) of the Tax Code says that a “service provider” that receives “property” “in connection with the performance of services” must pay tax on the difference between the value and the amount paid for the property. This seemingly innocuous section of the Tax Code can have serious repercussions for an entrepreneur launching a new business.
Consider the following: you are entrepreneur and have a terrific idea for a new business. You approach an investor, and he or she agrees to invest one million dollars in your venture in return for a 75% equity interest in the company. You agree to contribute your brilliant idea and your work toward the company’s success. Under these facts, you have received $250,000 of income that is taxable immediately. As the IRS views this transaction under Section 83(a) of the Tax Code, you have received a 25% equity interest in a business (“property”) worth $1M, have paid nothing to get it, and therefore owe tax on $250,000 of ordinary income. At a tax rate of 35%, this amounts to $71,428.57 of tax liability.
The same agreement can receive different tax consequences if the organization is formed as flow through entity, such as an LLC or partnership. In this situation, the Section 83(a) Tax Liability is measured by the liquidation value of the entity. With respect to the entrepreneur, the liquidation value is the amount the entrepreneur would receive if the entity were to sell all its assets and distribute the proceeds to its equity owners.
In the example above, and absent any provisions in the LLC or partnership agreement, the tax treatment would be identical. The entrepreneur receives a 25% equity interest in a business worth $1M, and upon its liquidation, the entrepreneur would receive $250K. Thus, for purposes of clarity AND immediate tax consequences, LLC and Partnership Agreements should address the issue of who receives what upon liquidation.
Section 83(a) operates differently where the entrepreneur’s equity interests are subject to vesting conditions, whether temporal (e.g., shares vest over five years) or performance based (e.g., shares vest upon reaching certain benchmarks). In this situation, it is critical to understand Section 83(b) of the Tax Code.
For further reading, see: Key Legal Issues Facing Start-Ups: Section 83(b) of the Tax Code