What are the Legal Requirements for Issuing Stock?

Companies generally issue securities to finance company operations. A security is defined by federal law and general includes any debt instrument, stock, or stock equivalent (such as options, warrants, ownership units, etc.). Federal and state government regulate the issuance of stock. The primary body regulating issuances at the federal level is the Securities and Exchange Commission (SEC). This agency works in conjunction with state agencies to reduce the risk that the general public is deceived or taken advantage of in a securities offering. These agencies do this through disclosure requirements.

As with individuals, companies must pay income taxes on profits or pass the tax liability on to shareholders. Shareholders receiving dividends or pass-through income from the company must pay taxes on those funds. Often, shareholders will seek to defer recognition of income. This is a common practice when the shareholder is an employee who receives stock as compensation or an investor who purchases shares of the company.

In this article we will discuss the applicable securities registration requirements, and possible registration exemptions. We will then discuss some of the primary tax considerations when issuing stock.

What is Securities Registration?

Public companies, whose shares are traded on public stock exchanges, must meet routine disclosure requirements. The applicable requirements are laid out in the Securities Exchange Act of 1934 and the accompanying regulations. Also, private companies that reach a certain revenue ($100 million annually), capitalization ($250 million of public float) and number of shareholders (2000 total or 500 non-accredited shareholders) qualify as “reporting companies” and must make similar public disclosures. The disclosures are very detailed and cumbersome. They include all relevant financial and operational information that an investor would find useful in deciding whether or not to purchase the company’s shares.

Many companies avoid going public or becoming a reporting company simply to avoid these onerous reporting requirements. Private companies are far less regulated in this regard. However, the SEC and state-level entities require that private companies register any specific issuance of securities to outside investors (not company employees). The rules applicable to private issuances of stock are found in the Securities Act of 1933 and the accompanying regulations. This means filing an extensive disclosure statement and providing a prospectus to all interested investors. Making these detailed disclosures is often too expensive and burdensome for a company seeking seed or early-stage investors.

To facilitate private company issuances, the SEC provides numerous statutory and rule-based exemptions from the requirement to register the securities or the issuance. The exemptions generally require that the company file a notice of issuance with the SEC (Form D) and provide a private placement memorandum (similar to a prospectus) to potential investors. This process is still detailed in nature, but it is far less rigorous that registering with the SEC. The primary registration exemptions are Sections 3(a), 3(b), and 4(a). The relevant rule-based exemptions are Rules 504, 505, and 506 under Regulation D. Also, Regulation A has become a popular securities registration exemption. Most states recognize these exemptions and offer limited or reduced filing requirements for companies perfecting an exemption under these various rules. The state filing requirements range from no filing at all to filing similar documents as required in the federal exemption. Many states make the process easier by allowing for full disclosure in one state that is widely recognized in other states.

Issuing securities pursuant to a registration exemption can still be a detailed and difficult situation. Generally, each rule has certain limits on:

• Where the securities can be sold;
• The amount of money that can be raised;
• Whether the securities can be resold by investors within specified periods of time;
• The financial status (accredited or non-accredited) or sophistication of the investors; and
• Whether the company can advertise or directly solicit investors.

These requirements make it necessary to work with an experienced professional when undertaking a securities issuance. 

Tax Considerations when Issuing Stock

Issuing stock is a valuable method for a company to finance operations. The company, however, generally wishes to avoid paying taxes on any funds acquired through the stock issuance. Further, the company wants to make any form of stock issuance as attractive as possible to investors or shareholders. As such, the company will seek to defer any taxation or avoid a transaction that results in a taxable event for itself of the shareholders.

The first consideration is, under what circumstances is the stock being issued? Is the stock simply being issued in exchange for capital investment? Is it being issued as compensation to employees? Or is it being issued in exchange for property being contributed to the company? The tax considerations are unique for each of these situations.

Capital Investment - Generally, a company does not recognize any taxable income when it receives funds from investors in exchange for stock. The investor receives the stock with a basis equal to what she paid for the stock. She will not pay taxes on the stock unless she later receives a dividend or sells the stock for more than she paid for it. There may be traps in place if the company issues stock at lower than its reasonable or fair market value to shareholders. It could be imputed as a payment constituting income.

Compensating Employees - Companies compensating employees with stock must get a professional valuation of the stock. The employee must pay taxes on the fair market value of the stock as income. The amount on which the employee is taxed becomes that employee’s basis in the stock. If she later sells the stock, she will pay capital gains tax (either short-term or long-term capital gains) on the increase in value at the time of sale. If the stock received by the employee vests over a period of time, the employee can make an 83(b) election and recognize the value of the stock as compensation immediately, or she can recognize the value of the stock at the time that it vests in the future.

Stock for Property - Companies issuing stock in exchange for property can generally defer the recognition of gain until the stock or property is later sold. This rule is what allows companies to undertake stock mergers that avoid tax recognition when shares are sold or traded. The basis in the stock will be the same as the basis in the property that was traded for the stock. The company will hold the property with a basis equaling the value of the stock issued. The company will only recognize tax on the property’s gain (which is generally includes any recapture of depreciation to the property) when it is sold.