Imposition of Vesting On Stock in a Financing

It is fairly common in connection with a financing that an investor will require a founder to agree to place a certain number of the founder’s fully vested and owned founders shares under an at-cost repurchase restriction, which at-cost repurchase right lapses over a new vesting period.

The question that this raises from a federal income tax perspective is whether the founder should or needs to file a Section 83(b) election upon the imposition of the new vesting conditions. The IRS answered this question in Revenue Ruling 2007-49.

“In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by (A) are subjected to a restriction causing them to be “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by (A) for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83.”

Excerpts from the Revenue Ruling:

Issues:

    1) Is there a transfer of substantially nonvested stock subject to § 83 of the Internal Revenue Code where restrictions imposed on substantially vested stock cause the substantially vested stock to become substantially nonvested?

Facts

    Investors form Corporation X in 2004, by contributing $1,000 each to Corporation X in exchange for 100 shares of Corporation X stock. In exchange for Individual (A)’s agreement to perform services for Corporation X, Corporation X issues 100 shares of its stock to (A). The fair market value of the Corporation X stock on that date is $10 per share. The shares of Corporation X stock transferred to A are “substantially vested” within the meaning of § 1.83-3(b) of the Income Tax Regulations.
    For the 2004 taxable year, the amount included in (A)’s income under § 83(a) is $1,000 (the fair market value of the stock ($10 x 100 shares) less the amount paid ($0)). (A)’s basis in the stock is $1,000.

As For Situation 1

In connection with its plan to start a new business venture, Corporation X seeks financing from Investor M on July 9, 2007. Investor M agrees to invest funds in Corporation X in exchange for a specified number of shares and the further requirement that (A) agree to subject (A)’s shares to a restriction that will cause the stock to be “substantially nonvested” within the meaning of § 1.83-3(b). Under this restriction, if the employment of (A) with Corporation X terminates before July 9, 2009, (A) must sell the shares to Corporation X in exchange for the lesser of $150 per share (the fair market value of Corporation X stock on July 9, 2007) or the fair market value at the time of forfeiture. In addition, the shares are nontransferable before that date. A remains employed with Corporation X, and on July 9, 2009, the fair market value of Corporation X stock is $250 per share.

In Situation 1, in connection with the new investment, the substantially vested shares of Corporation X stock owned by (A) are subjected to a restriction causing them to be “substantially nonvested”. Because the substantially vested shares of Corporation X stock are already owned by (A) for purposes of § 83, there is no “transfer” under § 83. Thus, the imposition of new restrictions on the substantially vested shares has no effect for purposes of § 83.

Conclusion

The IRS guidance is helpful, but in many cases, despite this guidance, taxpayers are going to want to file protective elections in any event. You should always consult a tax professional in considering these matters.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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