By S. Timothy Buynak, Partner

Planning Yields Prosperity!  This phrase is especially true when you are launching a venture, a start-up, with your new concept or service.  This Advisory considers the core foundations of your venture – – its securities and tax structure.  Plan and execute your company’s basic strategies so that they serve your best interests – – and those of your company’s investors and team.  Beginnings are important!

Early California Incorporation

Ventures and investors prefer corporations rather than limited liability companies, either a C or S corporation, for tax purposes.  As soon as your business plan is defined, we recommend that you immediately incorporate in California,[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1] if it is a California based business.  This allows:

1. For the issuance of “cheap stock” to the founders before financial entanglements;
2. For the development of a stock structure that contemplates investors, employees, contractors, etc.; and
3. Avoids unnecessary income taxes.[2]

Typical Tax Blunder

Here is the usual (unfortunate) scenario we see – – several founders contribute rights to technology they have developed to the corporation.  They agree to become employees to continue refining the technology for commercial purposes for 60% of the corporation’s stock; and to survive, they seek out “family and friends” to contribute $200,000, who receive the other 40% of the stock.

For tax purposes, upon IRS audit, this scenario will usually be characterized as a contribution of taxable services in exchange for stock.  With such a characterization, the founders would be liable for ordinary income tax on the fair value of the stock received, less what they paid (nothing).  This results in the founders having income tax on 60% of the $200,000 or $120,000 taxable income under Internal Revenue Code Section 83(a).  A result that certainly was not contemplated.

Internal Revenue Code Section 351 allows for a tax-free of transfer of property by controlling persons to a corporation on its formation but if the service component (future founder services) is substantial and not merely incidental to the transaction, the founders will likely need to not be found to have contributed Section 351 property, but instead have contributed a promise to perform services in exchange for stock.  This can easily be avoided by a proper securities and tax structuring.

Resolution

With proper planning, it is easy to avoid this unfortunate tax situation, yet achieve the same result – – ownership of the company by the founders and cash infusion, as necessary.[3]  While each company and their business are very different, the following is a typical securities and tax set up:

1. Early incorporation[4] with a low value for contributed intellectual property;
2. Authorization to issue, and issuance, of millions of shares of stock – – like 10,000,000 shares with 6,000,000 shares to the founders, 2,000,000 shares for investors and 2,000,000 shares for employees and contractors; and
3. Use of loans, debentures (loans convertible, voluntarily or mandatorily to stock), etc., all to delay a linkage to the initial founders’ stock, for tax purposes.

Through the foregoing allocation, the founders have the majority of the stock for control purposes, without tax liability.  In time the founders’ stock will increase in value until the first funding of the company through investors.  The amounts paid by the founders for their stock does not need to have, nor should it have, any relationship to the stock price set for investors in the future.  The pricing of stock on subsequent grounds of financing should be directly related the value of the company and the stock at that time, rather than the value of the company upon formation.

The structuring of the stock within your corporation upon start-up is a key element to its future success.  In fact, it is essential to avoid substantial tax liability to the founders and service providers.  Just as we have worked with hundreds of start-ups, we look forward to assisting you with your company to help ensure its success and to achieve your dreams.

S. Timothy Buynak, Partner

TBuynak@BFASLaw.com

(Direct) 805.966.7575

This Advisor is one of a series of business, real estate, employment and tax advisories prepared by the attorneys at Buynak, Fauver, Archbald & Spray, LLP. This Advisor is not exhaustive, nor is it legal advice. You should discuss your particular situation with us or with your own attorney. Our legal representation is only undertaken through a written engagement letter and not by the distribution of this Advisor.

[1] For the usual California start-up, a Delaware incorporation does not offer any practical advantages over a California incorporation.  The Delaware taxing structure is significantly more expensive than California’s; there are additional administrative burdens (such as the registration to do business in California); California incorporations are simple and expeditious.

[2] This Advisory only considers basic securities and tax legalistics.  Intellectual property (patents, trademarks, trade secrets, copy rights, domains, etc.) with appropriate employment, confidentiality, non-disclosure, licensing, invention assignment, and other agreements should be considered at or before incorporation.

[3] The usual minimum capitalization for incorporating in California to avoid “piercing the corporate veil” and subjecting officers and directors to personal liability for company liabilities is $30,000.

[4]  There is a need for separation between the initial incorporation with its founder’s stock and second round financing, so that there is not an IRS Section 83(b) concern.

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