What happens if the equity received by the shareholder is in exchange for services to the corpora.on?
Providing services to a corporation in exchange for stock is generally a taxable event. Pursuant to IRC Section 83(a), the shareholder receiving the stock will be attributed with income equal to the fair market value of the stock at the time of issuance. There is an exception to this rule under IRC Section 83(b). This section allows shareholders to defer the recognition of the income until a later date if certain conditions exist. In summary, the shares awarded to the shareholder must face a “substantial risk of forfeiture”. This means that there are provisions in the agreement that keeps ownership of the shares from ves4ng in the shareholder for a period of time. The most common type of restrictions is a stock award that is subject to vesting schedules and forfeiture provisions. This will allow the shareholder to defer recognition of the income until the substanial risk of forfeiture is no longer in place. This may occur once ownership of the shares of stock has fully vested in the shareholder. The downside is that shareholder will be taxed on the value of the stock at the time the substantial risk of forfeiture is gone. If the stock rises dramatically in value, the shareholder will face a much higher tax liability.
- Example: John receives stock in exchange for his services to New Corp, Inc. The stock award agreement states that ownership in a certain percentage of the shares will vest over several years. If John fails to meet certain performance levels or leaves the employ of New Corp, then all non-vested shares are forfeited. This would be sufficient to constitute a substantial risk of forfeiture. John will recognize income when the shares vest and there is no longer a risk of forfeiture in place.
How can a shareholder elect to immediately recognize as income shares that are subject to a risk of forfeiture?
IRC Section 83(b) allows a shareholder receiving stock for services that is subject to a substan4al risk of forfeiture to recognize the value of the stock as income in the year distributed. This allows the shareholder to recognize the stock as income before the stock increases in value. This is incredibly valuable for startup entrepreneurs who expect rapid growth of the corpora4on and value of the shares of stock. The risk associated with making an IRC Section 83(b) elec4on is that the value of the stock will decrease, as there is no subsequent deduction allowed to the taxpayer. In such a case, the shareholder incurs income tax on the higher value.
- Example: Sarah agrees to work for the corporation in exchange for a salary and an equity holding in the company. She will receive 1% ownership stake in the company at the end of each year for 3 years (her vesting schedule). If she leaves the company prior to the end of 3 years, all of her stock interest is forfeited back to the corporation. The contingency that Sarah stay at the company 3 years before owning her equity interest cons4tutes a substantial risk of forfeiture. Under IRC Section 83(a), Sarah can defer recognition of the stock award as income until the end of year 3. If, however, she chooses to recognize the stock award as income at the 4me that it vests (at the end of each year), she can elect to do so under IRC Section 83(b). Electing to recognize the income in the year awarded may lower her tax liability, as the stock will likely rise in value. If she waits until the end of year 3 to recognize the total value of the vested stock, she will pay income on the present value of the stock at that 4me.
- Note: Shareholders may not want or be able to pay the taxes on issues of stock for services, as she does not receive any cash along with the stock. In such a case, the shareholder may nego4ate with the corporation to provide a bonus, known as a “gross up payment”, to cover the taxes on the value of the stock received.
What happens if the equity received by the partner is in exchange for services to the partnership?
When a partner receives an ownership interest in exchange for services to the business, the partner is taxed on the value of the fair market value of the partnership interest received. This situation gives rise to “phantom income”, as the new partner does not actually receive any cash for her services. The partnership may award an interest that is subject to a ves4ng schedule and a substantial risk of forfeiture. The partner does not recognize income un4l the substantial risk of forfeiture is gone. If the partner wishes to recognize the value of the partnership interest as income at the time that it vests, she can make an IRC Section 83(b) election. This provision func4ons identically as in the corpora4on scenario.
- Example: Venus performs services to the partnership and receives a 10% partnership interest in exchange. The value of the partnership is $100,000. Venus will be taxed on the $100,000, even though she did not actually receive any funds. Venus may receive the ownership interest on a vesting schedule with forfeiture provisions if Venus leaves the partnership for any reason. As such, she will pay taxes on the value of the interest at the time it vests.
- Note: Unlike IRC Section 351 applicable to corporations, the distribution of equity for services as part of an IRC Section 721 transaction involving the contribution of property does not destroy the ability to defer the recognition of gain or loss on the contribution.
- Note: Rather than giving an ownership interest to individuals providing services to the business, partnership often award a profits interest in the business. A profits interest is a contractual right to share in the profits of the partnership pursuant to the terms of the profits interest agreement. The notable difference between an ownership interest and a profits interest is that the profits interest does not entail the other rights and liabilities associated with ownership.