Posts by BlaisTaxLaw

Tax Treatment of the ‘SAFE’ and ‘KISS’

The SAFE, or Simple Agreement for Future Equity, and the KISS, or the Keep It Simple Security, have become a popular way for early stage companies to raise money.   These securities were intended to be simple, low-cost alternatives to convertible debt.  But tax considerations have proved to be a source of uncomfortable uncertainty, especially for questions of when to start holding periods, QSBS qualification, and the allocation of expenses to the equity owners of a tax partnership.  To help cut through the fog, BHLG attorney Ben Damsky has published the first comprehensive analysis of the tax treatment of SAFEs. In short, Ben concludes that that while a tax classification for these securities as a forward contract is supportable, an equity designation is also supportable, and the latter is likely more favorable for taxpayers.   Click here to read the article, or reach out to Ben or another member of the BHLG team for additional information on the tax treatment of the SAFE and the KISS.

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Tax Reform Blog: Big Changes to NOLs Decrease Their Value

The Tax Cuts and Jobs Act of 2017 provided significant changes to the net operating loss (“NOL”) system for corporate and individual taxpayers, including:

  • NOL can no longer offset all of a taxpayer’s net income in a subsequent year. Instead, NOLs can only offset a maximum of 80% of net income. For corporations, this rule effectively produces a 4.2% minimum tax rate on current year income, regardless of the magnitude of its NOL carryforwards.
  • NOLs can be carried forward indefinitely (instead of for only 20 years), but generally they can no longer be carried back to prior years.

These rules are generally effective for NOLs arising in taxable years after 2017; NOLs generated in prior years will be subject to the old rules. As such, businesses with historic NOLs will effectively have some phase-in time as they use up their historic NOLs.

Growth companies have few resources in abundance other than talent, enthusiasm, and NOLs. Unfortunately, these changes make the NOLs less valuable. Consider these situations:

  • Reaching profitability. If a growth company became profitable after years of incurring losses, NOL carryforwards could shelter its net income from tax for several years. Now, at least 20% of its net income will always be taxable. For a company with boom and bust years of alternating profits and losses, the timing of income and expenses is suddenly important; and they may want to find a way to “smooth” earnings if possible. Needless to say, this is a substantial complication in tax planning.
  • M&A targets. Growth companies going through an exit event may feel the sting in two scenarios.
  • First, a company that was never profitable may nevertheless have significant capital gains from selling its appreciated assets, like IP or goodwill. It may face a tax liability notwithstanding a bounty of NOL carryforwards. Worse, the target may then liquidate or otherwise not earn a net profit again, rendering the unused NOLs permanently worthless.
  • Regardless of deal structure, previously profitable M&A targets often generate net losses in the year of sale because of one-time, transaction-related deductions, such as sale bonuses, option cash-outs, etc. By carrying back the resulting NOL, the target or its shareholders could generate a nice windfall of extra cash in the form of a prior year tax refunds. Eliminating NOL carrybacks forecloses this strategy. Instead, owners of S corp and partnership targets will need to wait for future net income. Owners of C corp targets may try to negotiate a purchase price adjustment with the buyer. Although the NOLs may now be carried forward indefinitely, buyers will generally be ungenerous to such efforts. On top of the 80% limitation described above, annual use of the NOLs will still be generally limited by the Section 382 “ownership change” rules. Further, buyers traditionally chafe at the tax benefits sellers enjoy from paying transaction-related compensation and other expense, financed of course by the buyer’s cash.

 

 

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Tax Reform Blog: Simple but Dramatic Tax Cut for C Corporations

 

The Tax Cuts and Jobs Act of 2017 may consist of more than 1,000 pages of statutory text and committee explanation, but the top headline is simple: “21% Corporate Tax Rate.”

More specifically, the graduated tax rates for C corporations that maxed out at 35% have been replaced with a 21% flat rate. Though broadly applying to all worldwide income of U.S. corporations, the consensus view is this dramatic rate cut has an international audience.

Related Legislative Changes

  • Repeal of corporate AMT. There would be no point to a new, flat 21% tax if corporations were still subject to an alternative minimum tax that kept their effective tax rate higher. The corporate AMT has been repealed. (In another post, we’ll describe how the individual AMT wasn’t repealed, but will apply to far fewer taxpayers.)
  • Reduced DRD. When corporations own stock in other corporations and receive dividends, the double-tax on corporate earnings distributed to shareholders can become a triple-tax, quadruple-tax, etc. To dampen this effect, corporations are entitled to a “dividends received deduction” (DRD) permitting them to exclude from income all or a portion of such dividends. The percentage of exclusion depends on the upper-tier corporation’s percentage of ownership of the lower-tier corporation. For dividends from ≥ 80% subsidiaries that could (or must) file a consolidated return, the DRD is and remains 100%. But as a revenue offset to the overall corporate tax cut, the DRD has otherwise been dialed back. For ≥ 20% subsidiaries, the DRD has been reduced from 80% 65%. For “portfolio investments” of corporations (< 20% ownership), the DRD has been reduced from 70% to 50%).

Some Practical Consequences

  • C corporations more attractive generally. The 21% rate obviously makes C corps more attractive as a form of business organization when compared to the top 40.8% rate that could apply to individuals earning flow-through income from S corps and partnerships. (The new top individual rate of 37% + 3.8% Medicare tax = 40.8%.) We will dive deeper into the choice-of-entity issue in a later post, but suffice to say this may change the choice-of-entity calculus for both new and existing companies.
  • Recompute the “double-tax rate.” A lot of business decisions, from choice of entity, to paying compensation vs. paying dividends, to preferred M&A transaction structure, require a rough application of the corporate double-tax rate, e., the aggregate taxes on $1 earned by a C corporation, which then distributes the after-tax earnings to shareholders. The double-tax has long been over 50%, and maybe over 60% counting state taxes. Now, once a C corp pays 21% corp tax and distributes the after-tax balance to an individual shareholder who is taxed at 23.8%, the maximum federal double-tax should be 39.8%.
  • Retained earnings — incentive & limitations. Of course, the double-tax only applies if a corporation’s after-tax profits are distributed as dividends. A C corp that retains its earnings can defer almost half of that tax until some indefinite future time. There are, however, important limitations on this strategy:

Shareholders may want or need cash. Not to be underestimated.

Accumulated earnings tax. Once upon a time, before Ronald Reagan, there was an even greater disparity between the top individual and corporate tax rates than prevails today. The C corp rate was 35%, but the top individual rate was a whopping 70%. Even when the top rate was decreased to 50% in 1981, dividends were taxed at ordinary rates. The rational and widespread retention of C corp earnings led to the “accumulated earnings tax” (AET), which imposes deemed-dividend treatment where a C corp’s retained earnings exceed “the reasonable needs of the business.” (Fun fact: the AET is one of the only federal taxes that is not self-assessed; it is only payable when imposed by the IRS.) Largely irrelevant during the decades of parity between the top individual and corporate rates, the AET may now make a comeback.

Personal holding company tax. Another product of sky-high individual tax rates, the “personal holding company” regime has renewed relevance. Certain closely held C corps with high proportions of passive income face an additional 20% tax. Be careful with that ingenious plan to put retained earnings to work in passive investments.

Section 269A and service corporations. The TCJA has prompted lots of speculation and criticism in the popular and business press surrounding whether employees can and should provide services through personal C corps. Read the fine print, in this case Section 269A, which authorizes the IRS to re-allocate income between an individual and a personal service corporation formed to provide service to a single employer. In other words, the IRS can ignore the corporation and treat the employer as paying the individual corp owner directly.

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NEW: Tax Reform Blog

The Tax Cuts and Jobs Act of 2017 (“TCJA”), the most significant revision of the U.S. income tax laws in 30 years, is now the law of the land. We’ll be rolling out plain-English summaries of the most important business tax changes and what they mean to growth companies and their advisors, including the dramatic cut to the corporate tax rate, the 20% exclusion on “qualified business income,” a radically different approach to international taxation, important changes to net operating losses, and much more. We’ll also take a step back and assess how the TCJA impacts perennial tax questions for growth companies, like choice of entity, M&A structures, and equity compensation strategies.

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A Good Excuse to Answer Some Questions About 83(b) Elections (Including the Most Difficult Question of All)

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In what passes for “news” regarding 83(b) elections, the IRS recently issued final regulations that eliminate the need to attach a copy of an 83(b) election to the service provider’s federal income tax return for the year of the election. The change is intended to encourage the electronic filing of tax returns, which isn’t available if one needs to attach non-standard forms and statements like an 83(b) election.

To be clear, taxpayers still need to submit a paper copy of the 83(b) election to the IRS within the applicable 30-day deadline. The final regulations apply to property transferred on or after January 1, 2016, but taxpayers were already permitted to rely on identical, previously proposed regulations for transfers on or after January 1, 2015.

While we are on the topic, we should seize the opportunity to answer some of the most commonly asked questions about 83(b) elections. Although the rules are written more generally to apply both to employees and independent contractors, to any kind of restricted property, and whether the property is transferred to the service provider or a third party, let’s focus on the typical situation where you are an employee receiving unvested stock of your employer as compensation for services.

Q: What does an 83(b) election do?

A: As background, when property is transferred in connection with the performance of services, Section 83 governs the timing and amount of compensation income taxable to the service provider. The general rule is that the vesting date governs both the timing and amount of taxable income. That is, you recognize taxable income in the year in which the stock is substantially vested, in the amount of the difference between the stock’s fair market value on the vesting date and any amount you paid for the property.

The function of an 83(b) election is to make the grant date the relevant date, rather than the vesting date.  That is, you have taxable income as of the grant date, based on the fair market value of the property on that date.

In either scenario, upon the “compensation event” (i.e., the vesting date or grant date, depending on whether the 83(b) election is made), the income is taxable at ordinary rates and your holding period in the property begins.  Any further appreciation or depreciation of the stock is capital gain or loss.

Q: Why would I want to file an 83(b) election if doing so will accelerate my income?

A: True; normally you want to defer rather than accelerate taxable income. But the difference between the tax rates for ordinary compensation income (39.6% max.) and long-term capital gains (20% max.) may change your calculus.  If you expect the property to both increase in value and eventually vest, the 83(b) election allows you to start your holding period (long-term capital gains treatment requires you hold the property for more than a year) and apply the lower capital gains tax rate to any further appreciation.  Without an 83(b) election, the taxable income is deferred, but any appreciation between the grant date and vesting date is taxed as ordinary income instead of, potentially, long-term capital gains.

Q: Why would I not want to file an 83(b) election?

A:  An 83(b) election comes with risks.  If you forfeit the property, or if the property decreases in value (or becomes worthless) prior to vesting, you will have unnecessarily paid some taxes (an odious, despicable thought in our business).

You may think there’s a consolation prize in those scenarios. Because the property’s value on the grant date becomes your tax basis, you should logically get a capital loss if you later forfeit the property or dispose of it for a lesser amount. Unfortunately, under one of the most ludicrously unfair rules in the tax law, if you make an 83(b) election and later forfeit the property, your capital loss is limited to any amount you actually paid for the property out-of-pocket. In the event of a forfeiture, you get no tax loss for the amount previously included in your income by reason of the 83(b) election.

Q: So, how do I decide whether to file an 83(b) election?

A:  As you can see, making an 83(b) election is a calculated risk that the possibility of a lower tax rate on future gains outweighs the certainty of immediate taxation at ordinary rates.  As Dirty Harry would say, “Do you feel lucky, punk?”

In practice, the choice is easier for some service providers than others.  For instance, if you receive early-stage company stock with nominal value, an 83(b) election has nothing but upside.  At the other end of the spectrum, if the company is highly mature with a steady value, you will typically be happy to defer income and avoid the risk of forfeiting the stock prior to vesting.

Q: Can I file an 83(b) election if I receive stock options subject to a vesting schedule?

A:  No, with a very narrow exception. An 83(b) election cannot be made on compensatory stock options unless the options have a “readily ascertainable fair market value,” which functionally means the options are publicly traded. But even this exception is narrower than it appears, since a company’s options that are publicly traded by investors have dramatically different terms than those issued under the company’s equity compensation plans (regarding length, strike price, application of SEC regulations, etc.). Translating the price of the former into a price for the latter is likely too complex to satisfy the “readily ascertainable” value standard.

Q: Do I need to file an 83(b) election if the stock is fully vested when granted to me?

A:  Strictly speaking, no. Where property is fully vested when granted, this means the grant date and vesting date are the same, resulting in an immediate compensation event regardless of whether an 83(b) election if filed.

The complexity lies in determining whether the property is “vested” within the meaning of Section 83.  For tax purposes, property is vested if it is either (1) no longer subject to a “substantial risk of forfeiture,” or (2) transferable to any third party free and clear of any forfeiture conditions (more on this later). We often equate a “substantial risk of forfeiture” with a requirement for future services, but it can be any compensation-related condition, such as a requirement that the individual or company reach certain performance targets. So think carefully about all conditions before concluding that stock is fully vested, and if in doubt, consider filing a “protective” 83(b) election.

Q: Should I file an 83(b) election if vesting restrictions are imposed on fully vested stock that I already own?

A:  This question arises most in the context of preferred financing rounds, where founders holding fully vested common stock agree, as a condition of the financing, to subject those shares to vesting restrictions.  It can also arise in the M&A context, where shareholder/employees exchange their existing shares for unvested shares of the buyer in a taxable or tax-free transaction.

The key question is whether a holder of fully vested property is receiving any “new” property that is subject to the vesting restrictions. If vesting restrictions are simply being applied to the founder’s current shares, no 83(b) election is required. What often happens, however, is the founders receive “new” shares of some sort, albeit in a tax-free way. For instance, as part of the financing, the company may reincorporate in Delaware or the company may recapitalize to increase or decrease the number of common shares. If the founder exchanges his existing vested shares for new unvested shares, an 83(b) election is required to avoid any further appreciation from being taxed as compensation income upon vesting. The election would not trigger any additional income – the founder has “paid for” the new shares by exchanging the existing shares of equivalent value.

Q: How do I file an 83(b) election?

A: Mail your 83(b) election to the IRS service center where you would mail a paper copy of your income tax return if you were not including a payment. You can find the appropriate address on the IRS website.  You must also provide a copy of the 83(b) election to your employer and any person or entity to whom you transfer unvested property, such as an estate planning vehicle.

Q: What is the deadline for filing an 83(b) election?

A: An 83(b) election must be postmarked within 30 calendar days after you receive the restricted property. There are no exceptions, unless you are serving in the Armed Forces (or in support of the Armed Forces) in a combat zone, or the IRS determines that you are affected by a presidentially declared disaster or terrorist or military action.

The 30th day is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the day after the date on which you receive the property. For example, if you receive restricted stock on April 19, your 83(b) election must be postmarked no later than May 19. If the 30th day falls on a weekend or holiday, then the deadline is the next business day.

Q:  What if an 83(b) election contains a mistake?  Can I file an amended election?

A:  Once the 30-day deadline has passed, there is no process for amending an 83(b) election other than securing the IRS’ permission to revoke the election entirely.  In terms of what impact a mistake may have on the election, there is no official guidance, but our attitude is to keep in mind the underlying purpose of the election, i.e., to commit the service provider to immediate taxation vs. waiting until vesting.  So minor mistakes about your personal information, general description of the property, or vesting schedule will likely be disregarded.  On the other hand, if you are issued 100,000 shares and list only 50,000 shares on the election, the IRS would be dubious if you claimed you really meant to make the election on 100,000 shares when their value skyrockets.

Q: What can I do if missed the deadline for filing an 83(b) election?

A:  We knew you’d ask that. The most common question is also the most difficult. The 30-day deadline is hard and fast, and the IRS claims it lacks the authority to grant extensions.

First, let’s rule out having the company simply cancel and re-issue your stock on the same terms. The IRS will see through that sham in a second. Instead, the company could replace the stock with options or new stock with materially different terms.

If those solutions won’t suffice, there is another potential solution that we’ve employed in emergency situations. It’s ugly and must be customized to the specific facts, but it aims to accelerate the “compensation event” and reach the same tax result as if you had timely filed your 83(b) election. Recall that your stock is “vested” (and thus taxable in the absence of a timely 83(b) election) when there is no longer a substantial risk of forfeiture or the stock is transferable to a third-party free of the forfeiture risk.  Understandably, the company will not want to waive the vesting schedule and/or other forfeiture conditions. But it may consider making the stocktransferable under certain limited circumstances. Once the stock is transferable, the compensation event is triggered, ordinary income tax is due, and any further appreciation may be long-term capital gains. How to make transferability palatable to all parties is where the ugliness and customization come in. If and when you are ready to pull the big red emergency handle, we can discuss further.

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Final IRS Regulations Simplify Section 83(b) Filing Requirements

On July 25, 2016 the Internal Revenue Service issued final regulations that eliminate the need for taxpayers to attach a copy of an 83(b) election to their federal income tax returns for the year in which the property subject to the election was transferred, thus clearing the way for such taxpayers to file their income tax returns electronically. (Despite encouraging taxpayers to e-file, the IRS previously didn’t allow taxpayers to attach a copy an 83(b) election to an electronically filed return.)

To be clear, taxpayers still need to file with the IRS a paper copy of their 83(b) election within the applicable 30-day deadline. Taxpayers should keep a copy of the election for at least eight years after disposing of the property to which the election relates (to cover both the standard 3-year and extended 6-year and 7-year statutes of limitations).

The final regulations apply to property transferred on or after January 1, 2016, but taxpayers already were permitted to rely on identical, previously proposed regulations for transfers on or after January 1, 2015.

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LLC vs. Corporation for a Startup

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We are frequently asked the “choice of entity” question for startup companies; that is, whether a client’s newly-formed company should be an LLC or a corporation. Putting aside that LLC’s can elect to be taxed as C or S corporations, the question traditionally translates into tax lingo as a choice between taxation as a partnership versus a C corporation. Now, we tax lawyers love partnerships for the same reasons kids love Legos®, but they are far from optimal for every startup. Every client situation is different, but generally an LLC may be a good idea if the client may want to do any of the following:

1. Distribute operating profits.
Instead of solely a capital appreciation investment, the company will be a “cash cow,” generating operating profits and distributing cash to owners. Notoriously, a C corporation would pay a corporate-level tax (up to 35%), and the shareholders would pay a shareholder-level tax (up to 23.8%) on their dividends.  (That’s around 50% before state taxes. Ouch.)  If the company were an LLC, it would allocate profits to the members, who would pay a single level of tax, up to 39.6%, with no additional tax if and when the profits are distributed.

2.  Exit via asset sales or partial liquidity events.
The C corporation’s “double tax” problem is even more dramatic in the context of capital transactions rather than operating profits. There’s no capital gains tax break for C corporations, so if a liquidity event involves the company’s sale of assets, shareholders face the aforementioned 50% effective tax rate.  On the other hand, an LLC would pass the capital gain through to its members, whereupon individual members would only pay the long-term capital gains rate of 23.8%. Most shareholders plan to avoid this problem by selling their stock for one level of long-term capital gain, but a stock sale may not be an option. Buyers may insist on an asset purchase, either for the future tax benefits or to avoid unknown or unwanted liabilities. Additionally, the company may face “partial liquidity events,” where the company separately monetizes some but not all assets. Examples include an investment pool with multiple portfolio companies, a company with multiple divisions or lines of business, or an entity holding intellectual property with multiple applications or fields of use, each of which may be developed and financed through a separate subsidiary.

3. Use tax losses.
Most startups operate at a net loss during their early years (if not their whole lives). A corporation’s losses do not pass through to the shareholders, but rather accumulate as “net operating losses.”  NOLs may be carried forward to offset future net income for up to 20 years, but their use may be subject to limitations under the alternative minimum tax (AMT) or rules governing 50%+ ownership changes. An LLC’s losses pass through to the members and may be used to offset other taxable income.  This can be a significant benefit – if the member can utilize the losses. Unfortunately, pass-through losses are subject to an array of limitations relating to basis and capital accounts as well as the “at-risk” and “passive activity” rules.  In most circumstances, individuals must both (i) contribute their own capital and (ii) be active in the business to benefit from an LLC’s tax losses in the short-term.

4. Use equity as compensation or deal consideration.
In terms of equity compensation for key employees, corporations must choose between granting stock (tax now, capital gain later) or options/phantom stock (tax later but it’s ordinary income). LLCs may issue “profits interests” — potentially the best of both worlds (tax later at capital gains rates). Further, if the startup envisions acquiring other companies with equity, sellers may only receive tax-deferred corporate stock in limited circumstances (e.g., tax-free reorganizations or when the target shareholders take control of the buyer). It is much easier for sellers to receive tax-deferred LLC interests as deal consideration.

5. Implement complex economic structures.
LLCs and other tax partnerships are great for housing complex economic deals among founders, investors, and other equity owners. Examples include multiple tiers of priority distributions and returns of capital, carried interests, different profit splits for particular LLC assets, clawbacks, subordinated common interests, etc. Many of these concepts can be incorporated into a corporate charter with different classes of stock, but only clumsily.

6. Change your mind.
The flexibility of LLCs generally permits do-overs. If you’ve transferred valuable property to an LLC, the company can generally transfer it back to you tax-free. If company is an LLC and wants to convert to a corporation (or elect to be taxed as a corporation), that’s generally tax-free, too. Vice versa? Not so much.  Both a transfer of property back to the contributor and the conversion of a corporation into a partnership or disregarded entity are generally taxable events. LLCs also let you change allocations of profits and losses for the year any time before the original due date for that year’s partnership tax return (usually April 15 of the following year). You may want to heed the Book of Common Prayer’s admonition about marriage — a C corporation should be entered into “reverently, discreetly, advisedly, soberly, and in the fear of God.”

On the Other Hand…
Even if a startup company could benefit from pass-through taxation, there are reasons one might affirmatively prefer C corporation status. Most obviously, the administration and accounting are fairly simple; for early stage companies, simple = good.  Further, for overlapping reasons, tax-exempt and foreign investors (and the venture capital funds in which they invest) generally prefer owning corporate stock to LLC interests. So-called “qualified small business stock,” which can be sold with no federal tax at all if held at least five years, is only available for the stock of C corporations. Last but not least, executives holding LLC interests may be treated as “self-employed,” which implicates additional complexity and compliance burden. (See here for further information on the “self-employed problem.”)

Takeaway
All planning in life is essentially a prediction about the future. The right choice of entity for a startup company requires reasonable predictions about profitability, expected liquidity events, the usefulness of tax losses, the benefits of tax-deferred equity for compensation and acquisitions, the complexity of the economic deal, and the possibility of changing one’s mind. Weigh these factors against both the administrative complexity of partnership taxation and any affirmative reasons to prefer C corporation status.

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Using In-the-Money Stock Options Without Violating 409A

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As we often do, let’s start with some good news.  We have a new partner, Tom Greene, who has been practicing in employee benefits and executive compensation for almost 20 years.  In addition to his traditional ERISA practice, Tom is already making a difference in our core M&A practice with his deft handling of 409A, 280G, ISO, plan termination, and benefits diligence issues for buyers, sellers, and management teams.

In Tom’s honor, this edition of the Issue Spotter examines how in-the-money stock options may be useful to growth companies.  For this discussion, “in-the-money” means the strike price is below the fair market value of the underlying stock on the date of grant, and “growth company” means a relatively young private company whose equity and option holders intend to profit from capital appreciation in a sale of the whole company (rather than through distributions of operating profits or isolated equity sales).

Fun fact:  409A does not prohibit in-the-money stock options

Conventional wisdom says non-qualified options violate § 409A unless the strike price is at least equal to the fair market value of the underlying stock on the date the options are granted.  Ensuring an “FMV strike price” is generally a good idea for business, securities compliance, and other non-tax reasons, but it isn’t absolutely required by § 409A.

To set the stage, remember that § 409A regulates the timing of deferrals and payments for “deferred compensation plans.”  Generally, common stock options with an FMV strike price are not deferred compensation plans, and are thus exempt from § 409A.  Needless to say, being exempt from § 409A means broad flexibility in designing the vesting and exercise provisions for such options, making one’s life a lot easier.

Options issued in-the-money, however, are deferred compensation plans under § 409A.  While they aren’t exempt from § 409A, they can comply with it by, among other criteria, limiting and requiring exercise upon the earliest to occur of one or more of six permissible payment events:  death, disability, an unforeseen emergency, a specified time or fixed schedule, and, most importantly for growth companies, a change of control or separation from service.

How in-the-money options may be useful

Here’s what makes in-the-money options a real possibility for growth companies:  very few option holders ever actually exercise their options prior to a liquidity event or, to a lesser extent, a termination of employment.  It’s only a slight exaggeration to say that a typical option holder would barely notice if his or her options could only be exercised on the earlier of a change of control and/or separation from service.  With such restrictions on exercise, the options could comply with § 409A even if the strike price were below the fair market value of the underlying stock when granted.

While not normally the preferred approach, options with a nominal or below FMV strike price may be useful in certain circumstances.  Most obviously, the company and a new executive may want the executive to share in proceeds from a sale transaction from “dollar one,” that is, based on the entire per-share value upon the sale rather than just the spread between the sale value and the exercise price.  Or two or more employees may join the company and receive options at different times but, for various reasons, wish to receive similar equity compensation packages.  Startup advisors will recognize another example — a founder may have verbally promised options to certain employees, and the company may even have adopted an option plan and authorize options grants, but the options are never actually granted to the employees until the company’s stock has substantially increased in value.

Complying with, rather than being exempt from, § 409A has some distinct disadvantages, which is why “FMV strike price” is more common.  Most significant is the issue of “subsequent deferral.”  Subject to some rare exceptions, in-the-money options (like all deferred compensation plans) must be exercised or cashed out upon the relevant payment event, even if the option holder doesn’t receive sufficient cash to pay the resulting taxes.  For instance, the change of control may be a stock-for-stock reorganization with no cash consideration, or the separation from service may not include a sufficient severance package.  Drafting around this risk may involve additional advance planning and negotiation.

Takeaway

Issuing stock options with an “FMV strike price” surely makes tax and other legal compliance easier, but it is not absolutely required by § 409A.  There are circumstances in which in-the-money options may be useful.  Such options comply with § 409A as long as exercise is limited to and required upon certain events, most notably a change of control or separation from service.

For more information, please contact Travis Blais or Tom Greene.

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Thomas Greene Joins Blais, Halpert, Lieberman & Greene LLC

Boston, Mass. – December 1, 2015Blais, Halpert, Lieberman & Greene LLC (formerly Blais, Halpert & Lieberman LLC) is pleased to announce that Thomas M. Greene has joined the firm as a named partner and the head of our Executive Compensation & Employee Benefits practice as of December 1. For 17 years, Tom has advised businesses, executives, and nonprofit institutions on sophisticated compensation and benefits issues.

Tom brings new depth and breadth to the firm’s tax advice for buyers, sellers, investors, and management teams in high-value business transactions, combining deep experience with Section 409A, Section 280G, Section 162(m), stock options, and related compensation issues with hard-to-find expertise in ERISA, “plan asset” rules, and the Affordable Care Act.

Tom also has extensive experience designing, negotiating, and monitoring compliance for compensation and benefits programs for businesses of all sizes, from large public corporations to venture-backed, mid-stage companies, to tech startups. This practice includes advising plan administrators, boards of directors, and compensation committees regarding fiduciary duties and corporate governance responsibilities. Tom also assists educational, health, philanthropic, and other nonprofit institutions on their unique compensation and benefit issues.

C-suite executives regularly engage Tom when negotiating deferred and equity compensation, hiring, retention, severance, and management carve-out plans, change of control payments, and shareholder protections.

For his efforts, Tom has been recognized by Chambers USA and Best Lawyers in America as one of the top lawyers in the U.S. in the areas of Employee Benefits & Executive Compensation and ERISA. Various publications and media outlets regularly seek his views on employee benefits & executive compensation issues, including The Street, USA TodayBoston GlobeBoston Business JournalNational Law JournalCorporate Counsel Magazine, Employee Benefit News, WCVB-Channel 5 Boston, Fox News, Fox Channel 25, New England Cable News Network and WBZ Radio.

Prior to joining us, Tom was a partner with Holland & Knight LLP and Mintz, Levin Cohn, Ferris, Glovsky and Popeo, P.C.

Tom can be reached at (617) 918-7087 or TGreene@BlaisTaxLaw.com.

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Don’t Forget “Closer Connection” and “Tie-Breaker” Exceptions for U.S. Tax Residency

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As most immigration attorneys, private client attorneys, and other advisors know, a foreign citizen or national is considered a U.S. tax resident if he or she meets the “green card test” or the “substantial presence test.” But the analysis doesn’t stop there. Also consider whether the individual avoids U.S. tax residency through the “closer connection” exception to the substantial presence test, or its close cousin, the “tie-breaker” provisions of tax treaties.

Why It Matters
Obviously, whether a foreign citizen is a U.S. tax resident is an important determination.  U.S. tax residents pay U.S. taxes on their worldwide income, while non-residents generally pay U.S. tax only on U.S.-source income.  For an individual with income from non-U.S. sources (e.g., pensions, investment income, compensation for foreign employment) who otherwise would pay lower tax rates in a different nation, U.S. tax residency may have a significant price tag.  Plus, after eight years, U.S. tax residency becomes like the Hotel California. The Internal Revenue Code is programmed to receive: you can check out any time you like, but you can’t necessarily leave.

Substantial Presence and the “Closer Connection” Exception
Although “183 days per year” is a well-known touchstone of the substantial presence test, the true threshold is lower than that.  Because days present in the U.S. in the preceding year each count as 1/3 of a day, and in the second preceding year count as 1/6 of a day, spending an average of 122 days per year in the U.S. will make one a U.S. tax resident.

Enter the closer connection exception.  Notwithstanding substantial presence, and assuming no green card or green card application, an individual will not be a U.S. tax resident if he or she:  (1) spends fewer than 183 days in the U.S. in the current year; and (2) has a “tax home” and a “closer connection” in another country.

For this purpose, an individual’s tax home is considered to be his or her main place of business, employment or post of duty. If none of these apply, the tax home will be where the individual resides for a majority of the time.  Whether an individual has “closer connection” with a foreign country is based on all the facts and circumstances, including the residence claimed on official documents, place of voter registration and driver’s license, where he or she derives a majority of income, and the location of family, permanent home, personal belongings, furniture, cars, banks, and personal, financial and legal documents.

Treaty Tie-Breaker for Dual Residents
If an individual cannot satisfy the closer connection exception (e.g., spends 183 days or more in the U.S. during the year), there may still be hope under an income tax treaty’s “tie-breaker” provisions.

The U.S. has tax treaties with dozens of foreign countries, principally intended to help residents of one country avoid being taxed by the other country based on temporary travel or business connections.  For instance, tax treaties typically prevent a country from taxing business profits or compensation earned by the other’s residents unless the income is connected to some non-temporary physical presence, termed a “permanent establishment” or “fixed base.”

Sometimes, an individual is a “dual resident,” i.e., the individual qualifies as a resident of both countries under their respective tax laws.  For example, an individual may meet the substantial presence test in the U.S. but also spend enough time in the other country to be treated as a resident under its own laws.  Enter the “tie-breaker,” which in most treaties reads like this:

Where … an individual is a resident of both Contracting States, then his status shall be determined as follows:

  1. he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (center of vital interests);
  2. if the State in which he has his center of vital interests cannot be determined, or if he does not have a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;
  3. if he has an habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national;
  4. if he is a national of both States or of neither of them, the competent authorities of the Contracting States shall endeavor to settle the question by mutual agreement.

Note how the tie-breaker resembles the closer connection analysis, especially with respect to determining where “personal and economic relations are closer (center of vital interests).”  Once again, driver’s licenses and the location of family and bank accounts will be part of the discussion.

Some words of caution:  For the tie-breaker to apply, the individual must be a “resident” of the other country under that country’s own domestic tax laws.  This may not be obvious, particularly because unlike the U.S., most countries do not automatically treat their citizens as tax residents.  Consultation with a tax advisor from the individual’s home country may be necessary.

Moreover, the tie-breaker governs the dual resident’s residency only for purposes of determining the individual’s U.S. tax liability. It does not absolve the individual of U.S. tax reporting obligations.  The individual must still file Form 1040NR to report U.S.-source income and Form 8833 to claim treaty benefits.  Form TD F 90-22.1 to report foreign bank accounts and Form 8938 to report other foreign assets may also be required.  A tax return preparer with experience working with nonresidents is highly recommended.

Furthermore, a dual resident will still be treated as a U.S. resident in determining another person’s tax liability.  For instance, a dual resident may still be counted as a U.S. shareholder in determining whether a foreign corporation is a “controlled foreign corporation” whose “subpart F income” is immediately taxable to other U.S. shareholders.

U.S. Citizens and Green Card Holders
Neither the closer connection exception nor a treaty’s tie-breaker provisions are of any help to a U.S. citizen, including a dual citizen. The Internal Revenue Code treats citizens as per se tax residents, and U.S. tax treaties contain a “savings clause” reserving the IRS’s right to tax U.S. citizens notwithstanding any treaty.

Like citizens, green card holders are per se residents under U.S. tax law, meaning the closer connection exception does not apply. But nothing in a tax treaty precludes green card holders from availing themselves of a tie-breaker provision. That said, U.S. immigration law may treat a claim of nonresidency (even one solely for tax purposes) as a constructive surrender of one’s green card.  Tread very lightly and consult a good immigration attorney.

Takeaways
Just because a foreign citizen or national meets the “substantial presence test,” the individual is not necessarily a U.S. tax resident.  Always consider whether the closer connection exception or tie-breaker provisions of a tax treaty apply.  With respect to tie-breakers, one must further consider the individual’s remaining U.S. tax reporting obligations and the effect of filing a Form 1040NR on the individual’s immigration status.

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