Vesting Imposed On Founder Stock In Connection with Financing–Section 83(b) Election Required?

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.

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.

Related posts:

1. What Is A Section 83(b) Election?
2. Can An S Corporation Have Voting and Non-Voting Stock?
3. What’s Better For An Equity Incentive–Restricted Stock or A Stock Option?
4. What Size Venture Fund Will Be Required To Register With The SEC?
5. On What Date Do I Price Stock Options Granted To My Employees?