Taxation and Valuation of Stock Compensation Provided to Founders
An incremental stock grant issued to founders 3 years after founding a company is typically taxed as ordinary income based on the fair market value of the shares at the time of grant.
The founders would be required to pay taxes on the value of the shares as they vest, unless they file a Section 83(b) election within 30 days of receiving the grant. The value of the shares at each vesting period will be treated as taxable income, and as the shares vest over time, taxes will be due on the value of the shares as they vest each year.
Founders can choose to file an 83(b) election within 30 days of receiving the grant to pay taxes on the total value of the shares at the time of grant, potentially reducing their overall tax liability if the company’s value increases significantly. Any appreciation in the stock’s value after the grant (or after the 83(b) election, if made) would be taxed as capital gains when the shares are eventually sold.
It’s important to note that if the founders’ original stock has been held for at least three years before new restrictions (such as a new vesting schedule) are imposed, the IRS has ruled that these new restrictions can be ignored for tax purposes. However, this would not apply to a new, incremental stock grant.
To value the grant a 409(a) valuation at the time of the grant can be used for tax purposes, but with some important considerations.
The 409(a) valuation provides a “safe harbor” for determining the fair market value (FMV) of the stock for tax purposes, particularly for setting the exercise price of stock options.
If the 409(a) valuation is conducted within 12 months of the grant date and no material changes have occurred in the company’s circumstances, it is presumed to be reasonable for tax purposes.
However, the 409(a) valuation is not an all-purpose insurance policy. It specifically addresses the setting of exercise prices for nonqualified stock options or stock appreciation rights to determine whether they qualify for an exception from coverage under section 409A.
The valuation’s reliability may be questioned if:
It’s crucial to ensure that the valuation is current. A 409(a) valuation is typically valid for up to 12 months from the valuation date, unless there’s a reason to believe it’s no longer valid (e.g., receiving a term sheet at a materially different valuation).
For grants made while waiting for a new valuation, there may be risks if the new valuation (when received) shows a higher value effective from an earlier date.
In summary, while a 409(a) valuation can be used for tax purposes at the time of grant, it’s essential to ensure its timeliness and consider any material changes that might affect its validity. Companies should be cautious about relying on outdated valuations or using them in situations where significant changes have occurred since the valuation date.
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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.