Real-World Advice for Adding a Founding Shareholder to Your Company|
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At a glance
- The main takeaway: Entrepreneurs and founders often wonder about the best way to reward key employees who have helped build and grow their businesses.
- Impact on your business: There is a wide range of valuable compensation structures and plans to choose from, but the key is to enlist the help of an expert to properly plan for tax, accounting and business complexities.
- Next steps: Aprio’s Wealth Management team can provide the independent, unbiased advice and solutions you need to make the best-possible compensation decision for your business and team members.
The full story:
Whether you’re an experienced entrepreneur or you just founded your first startup, building a company from the ground up takes a village. There is often a wide range of key players, from early investors to ground-floor team members, who help founders bring their business dreams to fruition.
To reward those individuals and keep them on your team to continue to grow your business, you may decide to appoint one or multiple founding shareholders. Below, we share a real-world scenario to help you understand the process of adding founding shareholders and the available options from a compensation standpoint.
Setting the scene: adding a co-founder and offering compensation
Let’s consider the case of Felix, who founded a healthcare IT company that is developing an app that allows users to track their blood pressure through their smartphone. Felix is the sole shareholder of the corporation and has one key employee named Bob. Since its founding, Bob has helped Felix get the company to this point and he wants to appoint him as a co-founder. He is considering the best way to offer Bob ownership and asks his advisors what compensation alternatives he should consider.
The two best compensation alternatives that Felix can give to Bob are either a stock grant or stock options.
Understanding stock grants
Let’s assume that Felix owns 1,000,000 shares of stock in his company today.
A stock grant is a good choice to compensate Bob because this can provide him with immediate equity ownership in the company and build instant loyalty. For example, the company could grant Bob 20% of the shares in the company, or 200,000 shares of stock. These shares could be vested over several years (typically three to five years). Generally, the shares will vest over a specific time frame, and at the end of the vesting period, Bob would own those shares without any restrictions or limitations. If Bob left the company prior to the full vesting period, he would retain the vested portion of the shares. Granting stock can have a real, tangible impact on keeping employees working during good and bad times.
How are stock grants taxed?
Assume the value of Bob’s 200,000 shares is $5 per share, or $1,000,000. When Bob received this stock grant, he would have to pay tax on the $1,000,000 at that time, or he could wait and recognize the income as the 200 shares vest over time. Bob also has the ability to make a tax election under Internal Revenue Code (IRC) Section 83(b), whereby he would recognize the value of the shares immediately, which also starts the clock on the holding period for taking advantage of long-term capital gains tax rates and IRC 1202 benefits.
Bob’s basis in the shares would be equal to $1,000,000, and this amount would be included as wage income on his payroll. He would have a 30-day window to make this election and no ability to make a late election. Bob would have to remit approximately $400,000 of tax due on the value to the company to allow it to remit the withholding taxes for payroll.
If Bob received the stock grant and either decided not to or failed to make a timely 83(b) election, the tax consequences would be very costly in the future. In this case, as the shares vest (restrictions lapse) each month, quarter or year depending on the vesting schedule, the shares vested at each cycle would be considered income at that time at that value.
Let’s say the 200,000 shares vested annually at 25% per year — if the share price increased to $10 per share at the end of year two, and 50,000 shares were vested, those shares would be worth $500,000. The company would be required to report this amount as wages and Bob would have to remit approximately $200,000 in tax to the company. If the value continued to rise, Bob would quickly regret not making an 83(b) election.
If Bob could not afford the tax cost to make an 83(b) election, this path wouldn’t be wise, and the company would need to look at stock options as a more affordable way of accomplishing its goal of awarding equity to Bob.
If Bob made the 83(b) election and recognized income and the stock became worthless, then he would have a capital loss he could claim personally.
Assuming a stock grant wouldn’t work for Bob, let’s consider the impact of the company awarding him with 200,000 stock options with a strike price of $5 per share.
The biggest difference is that Bob would receive the grant, provided that he would buy the shares at a future date. In this case, Felix should consider offering two main types of options to Bob: incentive stock options (ISOs) and nonqualified stock options (NSOs).
Understanding stock options: ISOs and NSOs
ISOs come with many qualifying requirements under Reg. 1.422-2, but the two that are most applicable to Bob are:
- He must be an employee, and
- The total value of the options provided to him is limited to $100,000 annually (any excess is automatically considered an NSO).
If the option grant does not specify that it is an ISO, then it is automatically considered an NSO. Most nonemployees and board members are typically granted NSOs by companies.
ISOs and NSOs typically have vesting schedules, which determine when the options can be exercised. Most of these have a vesting cliff, which is when the first portion of the option grant vests. After the cliff, employees usually vest the remaining options each month, quarter or year. Many companies offer option grants with a one-year cliff, which means the recipient must stay at the company for at least a year if they want to exercise any options.
Stock options are not taxed at the grant date or the vesting date. When exercising both ISOs and NSOs, employees would remit to the company the strike price multiplied by the number of shares they exercise. But for an NSO, employees would also remit income tax due on their “phantom income,” which is the spread between the strike price and the current fair market value (FMV) as determined by a 409A valuation (FMV is an appraisal of the value of a company for tax purposes).
In this example, let’s assume Bob exercised 100,000 options with an FMV of $80. He could either exercise and hold, or exercise and sell.
If Bob had ISOs and exercised and held the options, he would not be subject to income or capital gains tax. However, the difference between the strike price and the FMV on the day he exercised them would count as income for calculating federal alternative minimum tax (AMT). The company would provide him with IRS Form 3921 so he could compute that tax. If he sold immediately, Bob would have a disqualified disposition, which is triggered if the stock was sold within one year of exercise or two years of the grant date. That income would be taxed as wage income.
Now, let’s assume that after five years, Felix sold the entire company for $80 per share. Since Bob held the stock for more than one year, he would get long-term capital gains tax treatment on the difference between the strike price and the sale price (100,000 shares multiplied by $75, or $7,500,000). He also may be eligible for a complete exemption under the IRS Section 1202 Qualified Small Business Stock (QSBS) exemption.
If Bob had NSOs and exercised and held them, he would receive phantom income. As I stated above, this is the difference between the strike price and the FMV at the date of exercise and would be compensation income (100,000 shares multiplied by $75, or $7,500,000). Employees have this reported on payroll, subject to withholding taxes, and nonemployees have this reported on Form 1099-NEC.
When Bob sells, he will have a capital gain, which is taxed on a long-term basis if he held for more than one year, and on a short-term basis if he held for less than one year. Bob’s basis in this stock would be the strike price per share, plus the recognized phantom income (or the FMV per share at the date of exercise).
The bottom line
Felix has his own, unique perspective when considering the best path to equity participation for Bob — but ultimately, it is important for him to share his objectives with professional, expert advisors in order to assemble the best plan for both Bob and the company.
No matter which plan you choose for your own employees, there will be several tax, accounting and business consequences you’ll need to consider, so early planning is essential. At Aprio, our Wealth Management team is deeply experienced in helping founders establish the right equity compensation programs for their key employees. We’re here to provide the independent, unbiased advice and solutions you need to make the best-possible decision for your business and team members.
To start the compensation planning process, schedule a free consultation with our team today.
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