As discussed in Previous Articles, we saw how Section 83(a) of the Tax Code imposes ordinary income tax on “property” received by a “service provider” “in connection with the performance of services.” We also saw that Section 83(a) postpones taxation (and valuation) until any vesting conditions have been completed. Only when the equity is no longer subject to a “substantial risk of forfeiture” does 83(a) value and tax the shares. Finally, we saw that the “service provider” (i.e., the entrepreneur) can make a Section 83(b) election to lock-in the value of the shares at the time of grant.
This article will cover how to minimize taxation under Section 83(a) (or even eliminate it entirely).
Section 83(a) only taxes the “spread” on shares issued to the entrepreneur. That is, if the entrepreneur pays fair value for the shares, there is no taxable event. Consider the following example:
Entrepreneur and an investor agree to go into business. The entrepreneur will contribute his or her ideas and a promise to work on the business. The investor will contribute $1M. Both will receive 50% of the entity’s equity.
Under these basic facts, the entrepreneur has clearly received $500K of Section 83(a) property that is taxable as ordinary income.
Now consider the following modification:
Entrepreneur and an investor agree to go into business. The entrepreneur will contribute $50K (through some combination of cash and a promissory note), his or her ideas, and a promise to work on the business. The investor will contribute $990K. This time however, the investor structure the transaction so as to receive $500K of non-convertible debt, $400K of non-convertible preferred stock, and $50K of common stock. Both will receive 50 shares of the entity’s common stock.
Under these facts, there is no Section 83(a) gain because the entrepreneur is paying fair value for the shares. And E still receives 50% the upside potential in the enterprise, as both the debt and preferred stock are non-convertible.
As these two examples show, even the most basic start-up transaction needs to be structured properly to receive tax-efficient treatment.