All posts tagged Stock Options

The Unbearable Lightness (of Being an LLC)

LLC Stock OptionsI had a client press me recently about converting from an LLC (taxed as a partnership) to a corporation.  The client had been considering raising money from angels and wanted to grant traditional corporate-style stock option to employees.

I suggested that if he wanted to raise money from third parties (whether angels or venture funds) and grant traditional stock options to employees and service providers, that it would probably make sense for him to convert to a C corporation.

“Most investors don’t want to invest in a pass through company. Either an LLC or an S corporation,” I told him. “They don’t want to receive a Form K-1.  Plus, stock option style equity grants in an LLC are not easy; they require book ups and complex capital account maintenance accounting.”

He and his co-founder changed their minds about raising angel money. The client didn’t think they needed or wanted to raise money from third parties, but still wanted to give employees traditional equity incentives. Their concern was, if they converted to a C corporation and decided to sell down the road, the future buyer might only want to buy the company’s assets and not the stock – thereby giving rise to the dreaded double tax.

“It is possible that if you convert your LLC to a C corporation that you could spend several years growing the business, and then have a buyer demand to buy the assets and not the stock,” I said. “If that happened and you went ahead and had the C corporation sell the assets, there would be a corporate level of tax owed that you would have avoided had you remained an LLC.”

“However,” I added, “there are still a number of good reasons to be a C corporation, and the likelihood of what you described happening is, in my experience, not common. You see, most ‘up’ deals are stock deals, or structured one layer of tax transactions, such as reverse triangular mergers.”

The client remained uncertain. I couldn’t tell the him that what they were afraid of was out of the realm of possibility, because frankly, it was a possibility. I have seen it happen on a few occasions in my career (granted, it’s been a long time).  On at least one occasion in the past, a C corporation received an acquisition offer on its assets.  The buyer wouldn’t budge on its demand to buy assets and not stock. In that case, due to the adverse tax consequences, the C corporation had to pass on the deal.

“Well, we want to remain an LLC then,” the client said.

“OK,” I said “but keep in mind that if in several years an acquiror company wants to acquire your company in an all stock transaction, you won’t be able to defer your gain on a stock deal until you sell the stock.”

“What do you mean?”

“Well, it is not uncommon for some acquirors, especially public company acquirors, to purchase other companies in all stock or mostly stock transactions.  Meaning, your stockholders will receive a portion of the deal (at least 40%) in stock, which might not be liquid.  In that case, they won’t be able to sell it for some time.  But if you are an LLC, such an acquisition could not qualify as a ‘reorg’ under the tax law, thus you would be taxed on the stock as if you received cash and turned around and bought the stock.”

“That sucks,” he said.

“I know,” I replied.

“What do I do?”

He wanted me to make the decision for him; to end his agonizing over the decision. I couldn’t do it.  It was his business; his decision.

“If I just stick as an LLC,” he said, “just how bad will it be again?”

“Well,” I said, “you will have to worry about book ups, and capital account maintenance, and a complex LLC agreement. But there are worse things that could happen to you than spending quality time with your tax lawyers and tax accountants. Just enjoy.”

“Plus,” I added, “if you remain an LLC you will not have to worry about a double level tax on sale of the LLC and you can always convert to a C corporation later.”

Conclusion

Choice of entity is not always easy.  Sometimes it is agonizing.

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Where Do I File My 83(b) Election?

Where Do I File My 83(b) ElectionIf you have never filed a Section 83(b) election before, you might not know where to file it.

Increasingly, founders come to me who have been filing their Forms 1040 electronically. Many of these founders have never filed paper returns, and when I tell them they have to file the 83(b) election with the office of the IRS at which they file their returns, they don’t know what I am talking about. Because they haven’t been mailing in their Forms 1040, they don’t know where to file a Section 83(b) election.

They say to me: “I have e-filed the last few years so I actually don’t have an address when I look at my returns.”

The IRS Regulations make clear where you are required to file the 83(b) election.  They provide as follows:

“The election referred to in paragraph (a) of this section is made by filing one copy of a written statement with the internal revenue office with whom the person who performed the services files his return.”

If you don’t know where to find the physical address, you can refer to the instructions in Form 1040.

You can find these instructions at www.irs.gov/pub/irs-pdf/i1040.pdf. At the time of this blog post, the places to file were found on page 104.

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Stock Option Exercise Tax Math

Stock Option Exercise Tax MathExercising a stock option is not always as straight forward as you might expect. The reason? Taxes.

How to Calculate the Tax on the Exercise of an NQO

“Spread” means the positive difference between the fair market value of the stock underlying the option and the strike price.

Let’s do a math example. Suppose you have a nonqualified stock option to purchase 50,000 shares at a strike price of $0.05 per share. The current fair market value of the common stock is $3.75, according to the company’s latest Section 409A calculation. Meaning, the spread is $3.70 a share.
If you exercise your option in full, you will have to write a check for 50,000 x $0.05, for the strike price – for a total of $2,500.

However, when you exercise a nonqualified stock option, not only do you have to pay your employer the exercise price per share, but you also have to pay your employer the employee tax withholding due. This includes your income tax withholding and employee side FICA.

Thus, you will also have to pay the company an amount equal to the income tax and employee‑side FICA tax withholding on the spread. The “spread” here is 50,000 shares x (3.75 – 0.05), or 3.70 per share x 50,000, or $185,000. Income and employee‑side FICA on $185,000, assuming you are over the FICA cap, is going to be approximately $48,932.50. (This according to Randy Harris, payroll consultant (@getthepayroll). Thank you, Randy!, calculated as follows:

    $185,000 x 25% (supplemental withholding rate for pay under $1 million) = $46,250
    $185,000 x 1.45% (Medicare tax) = $2,682.50
    $46,250 + $2,682.50 = $48,932.50

But watch out, annual earnings over $113,700 will be exempt from the Social Security Tax of 6.2% BUT due to the Affordable Care Act, as of January 1, 2013, income over $200,000 will require an additional 0.9% Medicare Tax Withholding.

In addition, please see the attached link for a breakdown of tax rates applicable to other situations, and be sure to consult your accountant/advisor for specifics:  2013 Fast Wage & Tax Facts.

Finally, also be aware that this tax withholding satisfies the employer’s obligations, but may not satisfy the employee’s tax obligations in full. That depends on the employee’s other tax items. The employee may need to make additional tax deposits to avoid an underpayment penalty. The optionee should consult with his or her own tax advisor on this issue.

State Income Tax Consequences

This blog post doesn’t address potential state income tax withholding issues.

Conclusion

When you are planning to exercise, consult your company’s chief financial person. He or she can help you work through the tax math of the exercise.

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