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 is helpful, but in most 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.
