#04 ~ Stock Authorization, Issuance, and Taxation
Explaining why it's important to be methodical when authorizing and issuing stocks.
Welcome friends, both old and new.
Historically, I have used this newsletter as a way to explore interesting topics at the intersection of startups and law. (Things like antitrust, when to consult an attorney, and why candor is the key to a healthy attorney-client relationship.)
Today, we’re going to do something a little different. In this issue, I share a memo I prepared for a client, explaining how the tax ramifications of authorizing and issuing shares of a newly formed startup can be minimized. It’ll be a bit more formal, but a bit more educational as well. I hope you’ll enjoy it!
A Primer on Stock Authorization and Issuance.
Before explaining the impact of the issuance of stock on franchise taxes and individual taxes, I offer the following as a quick explanation of the stock authorization and issuing process.
When a corporation is formed in Delaware, it files a Certificate of Incorporation with the Secretary of State. In that certificate, the corporation must authorize a certain number of shares at a certain par value. Should the corporation ever need to issue more shares–often in the event of a fundraising round–the corporation can authorize more shares. These shares represent ownership in the corporation, and, when issued, entitle the shareholder to certain rights as an “owner” of the corporation. The par value at which these shares are authorized indicates the legal value of the stock, or the lowest amount for which a share can be purchased.
Typically, the initial founders or early employers are issued shares of common stock, and in return they must pay the value of the shares, which is equal to the par value multiplied by the number of shares issued. Founders also typically contribute any intellectual property at this time.
Franchise Taxes
The first reason why the details of a startup’s stock issuance are important is that they dictate the startup’s franchise tax bill. In Delaware, corporations are required to pay an annual franchise tax, based on one of two calculation methods: the Authorized Shares Method or the Assumed Par Value Method.
Delaware’s Secretary of State explains the Authorized Shares Method as follows:
5,000 shares or less —> minimum tax of $175.00.
5,001 – 10,000 shares —> $250.00,
each additional 10,000 shares or portion thereof add $85.00
maximum annual tax is $200,000.00
For example:
A corporation with 10,005 shares authorized pays $335.00 ($250.00 plus $85.00).
A corporation with 100,000 shares authorized pays $1,015.00 ($250.00 plus $765.00 [$85.00 x 9]).
For corporations having no par value stock, the authorized shares method will always result in the lesser tax.
The Assumed Par Value Method is much more complicated, but typically more advantageous for startups.
This method “assumes that the value of each authorized share has a par value equal to its gross assets divided by the number of issued shares.” Delaware then uses the greater of this “assumed” par value and the actual par value to determine the corporation’s tax bill.
Explaining the process through an example helps clarify:
Company A authorizes 10 million shares of common stock with a par value of $0.00001. Company A has two founders that have each been issued 3 million shares of common stock, for a total of 6 million issued shares. The remaining 4 million shares have been reserved for employee stock options. Company A has $10,000 of gross assets, comprised of the founder’s cash and intellectual property contributions, along with some equipment purchased by the company.
Assumed Par Value = gross assets / issued shares —> $10,000 / 6,000,000 = $0.001667
Delaware uses the greater of the startup’s assumed par value and their actual par value to multiply by the total number of authorized shares to determine their assumed par value capital. In this case, the assumed par value ($0.001667) is greater than the actual par value ($0.00001).
Assumed Par Value Capital = (greater of assumed par value and actual par value) x (number of authorized shares) —> $0.001667 x 10,000,000 = $16,670
Delaware requires corporations to pay $400 for every million dollars of Assumed Par Value Capital, rounded up to the next million. This means that if the Assumed Par Value Capital is less than or equal to $1,000,000, Company A owes $400. If it is $1,000,001, Company A owes $800. Here, Company A only owes $400. Implicit in this method is the fact that the minimum tax for the Assumed Par Value Capital Method of calculation is $400.00.
While this may sound complex, the solution is relatively simple. Standard practice dictates that corporations intending to seek funding from venture capitalists do the following:
Authorize a reasonably large number of shares – 10,000,000 seems to be the standard.
Use a very low par value – $0.0001 or $0.00001 per share.
Issue a substantial percentage of the initial authorized shares.
These steps should allow a startup’s use of the Assumed Par Value Method to result in a franchise tax near the minimum of $400. It also will allow a startup to authorize enough shares to attract venture funding and issue employee stock options.
Individual Income Taxes
How startups issue stock is also important because it impacts startup shareholders’ individual income taxes. On this topic, it is important to be aware of two things: the 83(b) election and § 1202 qualified small business stock.
83(b) election
Often, when issuing stock to founders or employees, the stock is conditioned on the founder or employee working for the company for a certain period of time, also known as vesting. This means that the stock is subject to a substantial risk of forfeiture. Generally, when a stock is subject to a substantial risk of forfeiture, the owner of the stock will be taxed on it after it is no longer subject to said risk (i.e., after the stock becomes vested). When the stock does vest, the fair market value of that stock will then be counted as compensation income and subject to taxation.
This, too, is best explained by example. Let’s say Company B issues Employee #1 (we’ll call her Erin) 1,000,000 shares of common stock that vest equally over four years. The shares are valued as follows: $0.00001 on the grant date, $0.50 at the end of one year, $1 after two years, $3 after three years, and $10 after four years. For the purpose of this example, Erin’s ordinary income tax rate is 35 percent.
After year one, 250,000 shares will have vested, each worth $0.50. Erin will have income of $125,000, subject to 35% taxation, for a tax bill of $43,750
After year two, 250,000 more shares will have vested, but each share is now worth $1, so Erin has income of $250,000. With a tax rate of 35%, the tax bill is $87,500 for year two.
After year three, the shares have greatly appreciated and are now worth $3 each. When 250,000 more shares vest Erin now has income of $750,000 and a tax bill of $262,500.
Finally, after year four, the final 250,000 shares vest. Company B is doing very well and the shares are now worth $10. As such, Erin has income of $2,500,000 and a tax bill of $875,000.
Over the course of those four years, Erin has been subject to taxation summing to $1,268,750. However, it is important to remember that while Erin owns the shares, they likely are still highly illiquid. She will essentially be asked to pay taxes on income that has not yet turned into cash—i.e., income that could be gone tomorrow if Company B were to go bankrupt.
Fortunately, there is a solution: the 83(b) election.
Via the 83(b) election, stock owners like Erin can accelerate the tax on the shares of stock and the fair market value of all granted shares of stock are treated as compensation income at the time of grant. Then, any appreciation in the stock’s value will be subject to the capital gains tax, which is typically lower than the ordinary income tax.
It makes sense to return again to our example with Company B. The facts remain the same; however, this time, Erin promptly files an 83(b) election, as explained below. Now, when Company B issues her 1,000,000 shares, vested equally over four years, she is subject to compensation taxation on the full 1,000,000 shares on the day that the company grants her the stock. As a founder or early employee of Company B, Erin’s shares are issued when the shares are only worth the par value of $0.00001. As such, on the grant date, she has compensation of $10 ($0.00001 x 1,000,000 shares), and a tax bill of $3.50, which is substantially lower than the $1,258,750 tax bill accumulated when not utilizing the 83(b) election.
Fortunately, the 83(b) election process is very simple. Within 30 days of receipt of the stock, a stock grantee must send a letter to the IRS informing them of their election to include all of the granted stock in their gross income. The specific requirements of the letter are outlined by statute.
A few important considerations remain when considering whether to utilize the 83(b) election. First, an 83(b) election is not necessary for shares that are fully vested when issued or for stock options. Second, 83(b) elections are generally irrevocable. Third, when a founder or employee does not timely file an 83(b) election, the startup has the administrative burden of determining the value of shares every time shares vest (this is called a 409A valuation), reporting the value as income to the IRS, as well as employment tax obligations connected with the vesting shares. Finally, an added benefit of the 83(b) election is that it starts the long-term capital gains and qualified small business stock exclusion holding periods. When these holding periods are satisfied, it can result in substantial tax savings for the taxpayer.
§ 1202 Qualified Small Business Stock (QSBS)
Under section 1202 of the Internal Revenue Code, taxpayers may exclude up to 100% of the qualified gain of a qualified small business stock acquired after September 27, 2010. The exclusion has a cap of the greater of $10,000,000 or 10 times the adjusted basis of the stock.
Note from Nate: Qualified small business stock acquired before September 27, 2010 is also eligible for exclusion at lower rates and subject to a 7% alternative minimum tax. More on this here.
A qualified small business stock is stock in a domestic C corporation, originally issued after August 10, 1993. The corporation must have total gross assets of $50,000,000 or less, and the stockholder must have acquired the stock at its original issue (not on the secondary market) in exchange for money, other property, or services to the corporation. Additionally, during substantially all the time the stockholder held the stock, the corporation must have been a C corporation and at least 80% of the value of the corporation’s assets must have been used in the active conduct of a qualified business. It also must not have been a foreign corporation, domestic international sales corporation, former domestic international sales corporation, regulated investment company, real estate investment trust, real estate mortgage investment conduit, financial asset securitization investment trust, cooperative, or a corporation that has made (or that has a subsidiary that has made) a section 936 election. (Don’t worry if you didn’t know what any of those things are. They’re all pretty specialized types of organizations. If you think your company might be one of these, and if you have any questions about any of this, you should talk to a licensed attorney. To refresh: I’m not an attorney, I’m a law student, sharing things I have learned. Disclaimer here.)
A qualified business is any business that is not one of the following:
A business involving services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.
A business whose principal asset is the reputation or skill of one or more employees.
A banking, insurance, financing, leasing, investing, or similar business.
A farming business (including the raising or harvesting of trees).
A business involving the production of products for which percentage depletion can be claimed.
A business of operating a hotel, motel, restaurant, or similar business.
Finally, the investor must have held the stock for at least five years to qualify for the exclusion. This is where the 83(b) election impacts the 1202 QSBS exclusion. When the 83(b) election is filed, the five-year holding period begins. If the 83(b) election is not filed, the holding period begins when the shares vest.
Again, an example helps clarify. Company C is a technology startup that is a qualified business with qualified business stock. It was founded on January 1, 2015, and Founder, we’ll call him Frank, timely filed an 83(b) election. The founder invested $1,500,000 in Company C at its inception. On April 1, 2020, Frank sold Company C for $30,000,000. Because Frank filed the 83(b) election, the five-year holding period began in January of 2015 and is therefore satisfied. Frank’s adjusted basis is $1,500,000 because he invested $1,500,000 into the company at its inception. As such, Frank can exclude $15,000,000 (10 x the adjusted basis of $1,500,000), along with his original investment of $1,500,000. The result is that $16,500,000 of the sale is not subject to capital gains tax.
If instead Franks shares vested on the standard four-year vesting schedule referenced above, and Frank had not filed the 83(b) election, the five-year holding period required for the 1202 QSBS exclusion would not have begun until January 1, 2016–and even then it would only have begun for the shares that vested on that date. As such, when Company C was sold on April 1, 2020, Frank would not have qualified for the exclusion. This means that the entire sale, minus his initial investment, would have been subject to capital gains tax. His tax bill would have grown from $2,700,000 to $5,700,000–an increase of $3,000,000.
This concludes Issue #04 of Outside Counsel. I hope you found this informative and educational. If you did, please consider sharing it with a friend!
Finally, please don’t forget that I’m not an attorney and this is not legal advice. Check out the full disclaimer here.