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Income tax on stock for original founders?

6 points by markcray2 ↗ HN
A scenario:

Person launches startup, takes seed funding from angel investor at creation of company. Angel owns 60% for their capital contribution, Founder owns 40% solely for their future sweat contribution, no cash upfront.

Yes or No: The IRS sees the 40% ownership of the new company for the Founder as taxable income because the units are being given to the founder as payment for services being rendered...?

If Yes (which is what my advisors are telling me) — how do people deal with this tax liability? Do most founders put themselves (if their angel doesn't care one way or another) on a vesting schedule just to help spread out the tax burden over a few years?

Or is there some strategy of legal avoidance that I'm unaware of?

10 comments

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sohail
You're doing it wrong.

Talk to a real-live accountant.

dcurtis
You gave an angel 60% of your company?

You don't know if you will be taxed on your 40% contribution, and yet you already went through with the deal?

Your advisors are unable to answer your fairly simple questions?

Something is wrong here...

wright
It's probably family, not a formal investor.
tlrobinson
Let me preface this by saying I really have no idea what I'm talking about. But...

Equity is not considered "income". The only time you get taxed is when that equity is sold, in which case it's taxed as capital gains (if you've held the equity for longer than one year). Capital gains tax in the US is 15%, so it's a pretty good deal.

The bigger problem I see here is the angel taking 60-freakin-percent of the company! That's a huuuge chunk of the company for an angel investment. At the end of the day, you're not going to be left with much.

mlinsey
Equity can be considered income in some instances, depending on how exactly the transfer took place. For instance, stock grants such as Restricted Stock Units (RSU's) that you might get from working at a large company are certainly taxable income.
ojbyrne
As previously mentioned, the 83(b) election is the key thing. It just means you elect to get taxed on the stock when it is sold rather than when it's received.
mlinsey
First - founders should always be on a vesting schedule, just like everyone else. This schedule should be laid out in the founder's agreement. This isn't for tax reasons but in the case you have multiple founders and one of them leaves.

Second: giving 60% to an Angel investor is way too much, but I presume you picked a random number as an example. If you plan to raise a larger round later (from a VC etc), you should get a convertible note, where the Angel doesn't get a set amount of shares but rather the right to convert the note into $(amt invested) * (discount rate) at the time of the next round.

Third: Yes, you need to pay taxes on your stock as it vests. You should talk to your attorney about what's called the 83(b) option to mitigate this tax liability. Given that your stock is worth very little you should have minimal liability.

Fourth: I presume you just stated this scenario as a hypothetical and you haven't actually started a company and done this, much for the above reasons and what other comments have said. Do your advisors have experience launching/guiding a successful startup company before?

epi0Bauqu
I am not a lawyer, so don't listen solely to me.

No.

1) You shouldn't be giving up 60% in an angel round.

2) If the company is brand new, the shares should be worth essentially 0, which means you should be paying like $1 for them.

3) Your situation isn't entirely clear, but it seems that there is no taxable income here. You will have to pay capital gains taxes when you sell your shares, however.

4) If it is restricted stock (e.g. vesting), there is a tax issue. It is simple to deal with, however. Like others' have pointed out, you need to do a an 83(b) election. It is a simple one page thing, but you have to do it in a timely fashion. So look into it now. If you don't, you will get taxable income as your stock vests, which in most cases, is not what you want. The reason you don't want this is you will have to pay taxes on "phantom income," i.e. on taxable income that isn't associated with associated cash flow.

paul9290
Yes that is way too much of a percentage of your company to give up! Anything below 50% you lose the majority vote (try to keep 60% or more, if possible) and your idea due to you being a minority may get changed. In turn and in the long run your startup becomes a job rather then a passion!
markcray2
I apologize if some things were not clear. The situation described is hypothetical; while I appreciate everybody's concern about my giving away too much, the numbers here are made up, no deal has gone through, etc.

I think the 83(b) election is what I was looking for here. And yes, I'm definitely on the hunt for a new financial advisor/CPA, my current one is not up to snuff here. (The simple fact that they didn't mention the 83(b) possibility raises red flags.)

Asking the question here is simply to get some unfiltered, unbiased advice so that I have more to go off of when evaluating advisors, because yes, this is my first time taking on outside investment.

Where people are stating that the company value is essentially zero; if anybody has any links to throw out regarding how to value a company that has only taken a angel round, I would appreciate it.

The "equity is not income" argument; I've been told that my equity has to be given to me in exchange for something—just being the "founder" doesn't cut it. Since they're given to me in exchange for my services, it's considered taxable income.

Thanks for all the great feedback/conversation, I really appreciate it.