Sometimes a founder wants to lure a new executive to the company (or incentivize a current executive) with a meaningful stock grant, but there’s no room left in the company’s equity plan pool and the other shareholders aren’t excited about the potential dilution. So, the founder graciously offers to take the new grant out of the founder’s current shares.
I discuss below alternate paths for completing such a transaction and related tax considerations. For purposes of this discussion I am assuming that the company is taxed as a C corporation and that the executive is an employee.
Alternative 1
Founder surrenders shares to the company for $0 or some other amount and then the company makes a new grant to the executive.
Considerations:
- The forfeiture will be considered a capital contribution back to the company by the founder and the basis in the forfeited shares will be spread among the founder’s remaining shares.
- The new grant will be taxable to the executive on the value at grant (minus purchase price, if any), if the stock is vested or a tax code Section 83(b) election is filed, otherwise the stock will be taxed at vesting, on its value on the vesting date (minus purchase price, if any).
- The company has a withholding obligation at the time taxable income is recognized by the executive. This means the company will have to come cash out of pocket to cover employer-side payroll tax.
- The company gets a deduction equal to the amount of income recognized by the executive, provided that the amount meets the requirements of tax code Section 162 or 212 and the regulations thereunder.
- Prior to the new grant, the board will either need to increase the plan pool, which generally also requires shareholder consent, or the grant could be made outside of the plan.
- A securities exemption will be needed for the grant, but Rule 701 should be available at the federal level, subject to the 12-month limitation (greater of $1M/15% of assets/15% of class of securities). State blue-sky laws should also be considered.
Warning: If any consideration is paid to founder with respect to the share surrender, the forfeiture suddenly becomes a “repurchase” and as such it will count against the qualified small business “significant redemption” thresholds. Also, in such a case, the repurchase price will be taxable income to the founder, taxed either as purchase price (which allows for a basis offset) or a taxable dividend (which does not allow for a basis offset) depending on factors including whether the company has earnings and profits and whether the founder’s ownership percentage went down more than 20%.
Alternative 2
Founder transfers shares directly to executive for $0 or some other amount less than fair market value.
Considerations:
The tax rules pretend like the founder surrendered the shares and that the company subsequently issued the shares. See Treas. Reg. Section 1.83-6(d). So just like with Alternative 1:
- The shares will be taxable to the executive on the value at the time of receipt (minus purchase price, if any), if the stock is vested or a tax code Section 83(b) election is filed, otherwise the stock will be taxed at vesting, on its value on the vesting date (minus purchase price, if any).
- The company has a withholding obligation at the time taxable income is recognized by the executive. This means the company will have to come cash out of pocket to cover employer-side payroll tax.
- The company gets a deduction equal to the amount of income recognized by the executive, providing that the amount meets the requirements of tax code Section 162 or 212 and the regulations thereunder.
- Proceeds paid to founder, if any, are taxed the same as described above (i.e., purchase price vs dividend analysis would apply).
Things that are different from Alternative 1:
- The company needs to check and ensure that there are no transfer restrictions with respect to the founder’s stock or that such transfer restrictions are waived by the appropriate party (i.e., the company or the other shareholders).
- The shares received by the new executive likely cannot be qualified small business stock (QSBS), because they fail the rule that requires that such stock is received directly from the company. I would note, there may be a position that the tax fiction of a forfeiture followed by a direct issuance created by Treas. Reg. Section 1.83-6(d) would satisfy the QSBS rule, but I’m sure it’s a position the executive would prefer to not have to take.
Note: If desired, the vesting on the executive’s new shares can be structured such that the shares return to the founder, not the company, if they are forfeited in the future. If such shares do return to the founder, that will cause the founder taxable income equal to the basis of the transferred shares at the time of the original transfer. If such basis was nominal, then this would generally be acceptable to the founder, and it in any event would be more tax efficient than making a new grant to the founder in the future at the then-current-fmv if value has continued to go up. See Treas. Reg. Section 1.83-6(d)(2). One other way of solving would be to simply have founder’s shares be forfeited as the executive’s shares vest. This results in a little cap table bloat during the vesting period but ultimately would shake out to the correct ownership percentages and would avoid any tax to founder with respect to “returning shares” because the shares would have been retained, not forfeited and then returned.
Summary
If the company is a qualified small business, it likely makes sense to structure this transaction as a forfeiture and regrant, to allow the executive to potentially benefit from QSBS treatment. If on the other hand, founder would like some compensation for the shares or would like the shares to return to him or her if they don’t vest in the hands of the executive, then have the executive buy the shares from founder.
Mike Baker frequently advises with respect to the tax consequences of stock forfeitures and grants. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.