Issuing Equity to the Founders — Important Tax and Intellectual Property Considerations

Josh Rottner & Pat Mitchell, Cooley LLP

You and your co-founders have decided to form a legal entity and have agreed on how to allocate equity among yourselves and whether you’ll have vesting. Below is a brief discussion of some important tax and intellectual property (or “IP”) implications to be aware of as you issue your shares.

Source: Giphy

1. Are there any tax implications of receiving my shares?

So long as the purchase price that a founder pays for her or his shares of stock in a C Corporation is equal to the fair market value of the shares at the time of the purchase, then the purchase will generally not be a taxable event for the founder. However, embedded in this concept are a couple of important items for founders to be aware of:

· First, you have to pay for your shares.

Under the tax laws, if shares are sold at less than their fair market value, then the difference between the actual purchase price and the fair market value of the shares is taxable to person acquiring the shares. This means that the founders need to pay for their shares, which is often a surprise to our clients who are first-time founders. However as discussed below, we are generally able to structure this for a company’s initial founders (though not for future equity holders) so that they can pay the purchase price by transferring their intellectual property to the company in lieu of paying cash out of their own pockets.

· Second, it’s important to issue the founders’ shares right at the company’s formation.

It’s best to issue the founders’ shares when a company is first formed, because at that time the fair market value of the shares (and correspondingly, the purchase price that needs to be paid) is almost zero since the company’s only real assets are the ideas of the founding team. However, once you form the company and start working on its business, the company’s value can increase very, very quickly. So we strongly urge our clients to issue the founders’ shares immediately upon forming the company so that they can avoid having to come up with extra cash to pay the purchase price, or worse, the tax problems that would follow if the cash or intellectual property that they paid as the purchase price for their shares is less than the fair market value of those shares.

· Third, if you decide to have vesting, it’s important to file an 83(b) election with the IRS within 30 days from the date that your shares are issued.

For background, the default rule under the tax laws is that if you receive property in connection with your performance of services and the property is subject to vesting, then you won’t be taxed on that property until it vests, at which point you’ll be taxed based on the value of the property on the vesting date. While the default rule may work well in other contexts, it is problematic for shares in a startup. In a startup, everyone expects the value of the shares to increase significantly, so under the default rule you’ll be taxed when the shares are worth much more than they were when you paid for it.

The solution to this is to file an 83(b) election within 30 days from the date that the shares are issued. An 83(b) election is filed with the IRS to override the default rule and to tell the IRS that you want to be taxed when the shares are issued, rather than as they vest. Since your purchase price was equal to the fair market of the shares, your current taxable income should be zero and you won’t have to worry about taxation upon vesting going forward. It’s also important to note that the 83(b) election is also beneficial to the company, because without an 83(b) election, taxable income to the shareholder would be generated on each vesting date, which the company would then need to track and appropriately withhold for and pay employment taxes on.

For a deeper explanation of this topic on CooleyGo, please see: What is a Section 83(b) Election and Why Should You File One?, however the key take away is that if anyone receives shares that are subject to vesting, they should file an 83(b) election within 30 days from the date that the shares are issued. The 30 day deadline for filing an 83(b) election is a firm IRS deadline with NO EXCEPTIONS, so missing it is something that you can’t fix later.

2. What’s the best way to pay for my shares? I’ve heard that there are ways to use my IP as the purchase price. Doesn’t the company need this IP for its business?

Founders are sometimes surprised by this, but unless an agreement is in place expressly assigning intellectual property to a company, then the individual that invented a piece of IP may own it regardless of whether they invented it within the scope of their work for the company. We’ll discuss how to address this with the Company’s employees in a future post (spoiler alert: the key is to have everyone that does any work at all for your company sign an agreement assigning the IP created during their employment to the company when they start working), but founders are in a unique position in that they will not only develop IP while they work for the company, but they also created IP before the company was formed. When I say this to clients, many founders respond that there is no intellectual property that predates the company’s formation, but IP doesn’t include only patents, trademarks or copyrights — even the initial ideas and concepts for the business that you and your co-founders came up with as you decided to form your startup constitute IP that the new company will need to run its business.

Because founders are generating IP before the company is formed, we need to make sure that all of the founders contribute this IP to the company so the company owns the great ideas (and perhaps other IP) on which it is based. The company needs these IP rights to operate its business without infringing on the founders’ individual property rights, so if this IP isn’t contributed to the company, investors will be nervous about funding the company. Luckily, the founders’ pre-formation IP is also a valuable property right that the founders can use to pay for their initial equity — in essence they sell this IP to the company in exchange for their initial shares. Having the founders acquire their initial equity by using their pre-formation IP to pay the purchase price not only helps to make sure that the company owns all of the IP that it needs to operate its business as expected, but has the added benefit of allowing a founder to purchase her or his shares without paying cash out of their own pocket for their initial shares. Mechanically, the way to do this is to document the founder stock issuance with a restricted stock purchase agreement issuing the shares to the founder with vesting, and then have the purchase price paid with a technology assignment agreement in which the founder assigns her or his IP to the company in exchange for the shares.

The founders’ equity issuance documents are relatively straight forward, however since there can be significant tax and intellectual property implications, we do recommend contacting an experienced attorney to assist in preparing the necessary documents. If you would like to see the documentation involved, the relevant founder issuance documents can be generated through CooleyGo at: Incorporation Package (Delaware).

Background of the series “A Rough Draft of the Legal Basics”

As start-up lawyers, we spend our days working with talented, passionate and courageous entrepreneurs creating cool things. Our clients are on the cutting edge of software, social media, energy, ecommerce, robotics and space exploration. As companies mature, they face a variety of legal issues depending on their industry, strategy and stage of development. But at the very beginning, almost all start-up clients have similar legal needs and tend to ask the same questions. We have advised many companies (including some in the Rough Draft program) on these basic legal questions, and will be sharing our answers with the Rough Draft community in a series of posts on this site. This is part 3 in a series of posts on this site relating to these basic legal questions. Click here if you missed Part 1: Forming a Legal Entity or Part 2: Issuing Equity to the Founders — Initial Concepts.