Chapter 6 - Tax Discussion For The Non-Lawyer - Minimizing Taxes In The Early Stages
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
Tax considerations play a crucial part in the elections made upon the commencement of a start-up business. Tax concerns are ubiquitous in any financial environment, but mistakes made upon initial organization often cannot be remedied adequately; the opportunities are forever lost.
For purposes of this discussion, it is assumed that the corporate form has been elected. To understand fully the intricacies of those provisions of the Internal Revenue Code impacting various aspects of corporate organization, one must appreciate that the federal government does not impose a wealth tax on individuals' intangible assets. State and local jurisdictions tax property … real and personal … on an annual basis, and both the federal and state governments levy an ad valorem tax (measured by the value of the asset) on the estates of well-off decedents. However, at the federal level and in most states, paper wealth … cash and securities … is not subject to an annual tax on dormant value, and increases in an individual's wealth, without more, are not subject to a transaction tax while he is alive. Governments are not, however, sleepy. They want to take a portion of the individuals' increases in wealth … to share in their good fortune so to speak … but the governments have generally restricted themselves to assessing tax only upon the occurrence of certain events. It is thought easier to establish the amount of the increase, and therefore tax it, by focusing on transfers: the passage of assets from one hand, or form, to another. In organizing a corporation, therefore, the first rule is to circumvent taxable events: transfers which the Code (and state law) recognize as an occasion for asserting a tax. If a taxable event is unavoidable, the second rule is to eliminate or avoid gain if possible and, if not, to defer the recognition of such gain or, if the circumstances so warrant, to establish a loss.
Incorporation involves several transfers which might occasion tax. Thus, the organizing corporation typically issues stock in exchange for cash, property, or in some cases, expressly for services. The issuance of equity securities does not create income to the corporation. On the other hand, the recipient of the stock is, potentially at least, taxed on any gain resulting from the exchange. However, the recipient usually avoids tax, for a variety of reasons. Thus, payment for shares in cash, and only in cash, does not trigger a tax because no gain is recognized when one pays cash; the taxpayer's "basis" for tax purposes in cash is always equal to the cash paid. Similarly, the receipt of stock worth $100 for property with a tax "basis" ("basis" being a term of art with a structured meaning in the tax law, generally equating to "investment") of $100 does not involve gain or loss. The possibility of exposure occurs, therefore, upon the issuance of stock: (1) in exchange for appreciated property; and/or (2) in payment for past or future services (in those states where such services are eligible consideration for stock issuance), including occasions upon which the IRS recharacterizes a stock-for-property transaction as in fact stock for services.
Section 351 postpones gain or loss on the contribution of appreciated property to a corporation in exchange for stock, assuming certain rules are followed. Note that, although §351 is thought of principally in connection with organization of unseasoned start-ups, in fact the issuer can be newly organized or pre-existing when the stock issuance occurs; it can be any size, have an unlimited number of shareholders pre- and post-financing, and issue as many classes of stock as the situation warrants. The principle of postponing tax is not dependent on the resultant corporation being small or uncomplicated. The rule of §351 is that, immediately after the financing, the investors who contribute property and/or cash in exchange for stock in the transaction are in control; that is, they own at least 80 percent of the issuer's combined voting power (all classes of voting stock) and 80 percent of each class of nonvoting stock. If such is the case (and the property is not subject to liabilities in excess of its basis), no gain will be recognized on any appreciated property so transferred. And, according to the usual rules governing tax-postponed transactions, the tax basis of that property in the hands of the corporation will be "carried over" from the basis of the contributor, adjusted (increased) for any gain recognized by the contributor.
Note some of the things §351 does not do. It does not solve the "cheap stock" problem: when a founder, employee, consultant, and others are receiving stock in exchange for past or future services and want to avoid tax. In fact, if one of the stock buyers is paying solely in services and only services (past or future) and getting back more than 20 percent of the issuer's voting power, the entire transaction will be disqualified, much to the distress of the individual(s) in the buying syndicate putting up appreciated property.
The more significant question is implicit in the foregoing discussion. When is the founder's secret process "property" for purposes of §351 and when is it "services," occasioning tax to the founder and perhaps to other contributors of property relying on §351 to shield their gain? The distinction is, again, a little bit like the opposing nature of light … both a particle and a wave at the same time; a secret process is "property" … it has an owner and can be sold, and it is a reflection, a result, of past services, of capitalized labor. As Shakespeare has suggested, nomenclature is significant. The information should be legally protectable (i.e., at least a trade secret), and in fact adequate safeguards taken to guard the secret, original, unique, and novel (though not necessarily patentable) and not developed especially for the transferee. The information should not represent mere knowledge or efficiency resulting from skill or experience. It is helpful in this regard if any future services to be rendered by the transferee to the issuer respecting the process are bought and paid for under a separate contract negotiated at arm's length.