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Top 10 Tax Issues for Startup Companies

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Discussion of the top 10 tax issues for startup companies

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Top 10 Tax Issues for Startup Companies

  1. 1. Tax Issues for Startup Companies Silicon Valley, San Francisco, Los Angeles rroyse@rroyselaw.com www.rroyselaw.com
  2. 2. Roger Royse is the founder of the Royse Law Firm. Based in Silicon Valley, the Firm works with companies in a variety of industries, including clean tech, internet, life sciences, entertainment and new media, sports, real estate, retail and mobile devices and applications. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms as well as Milbank, Tweed, Hadley and McCloy in New York City. Roger has also served as an adjunct professor at the Gold Gate University Masters of Tax program. He is a frequent speaker, writer and blogger for American bar associations, CPA organizations, and business groups.
  3. 3. 1. Choice of Entity 2. § 305 Applied to Common Startup Scenarios 3. Starting Capital Issues (Including Dynamic Split Models) 4. Dynamic Split Models 5. Taxation of Stock Rights 6. Taxation for Compensatory Partnership Interests 7. Incorporation of an LLC 8. § 409A Deferred Compensation 9. Employee vs. Independent Contractor Issues 10. Debt-Equity Regulations and S corporation (§ 385 Proposed Regulation) Top 10 Tax Issues for Startup Companies 3
  4. 4. LLC (not taxed as corp) S Corporation C Corporation Entity Level Federal Income Taxes No federal tax at LLC level. Generally no tax at S corporation level; some excise taxes, and built in gains taxes may apply. Income tax on earnings at corporate level. Eligibility Requirements of Owners and Equity No restrictions. US citizens or resident individuals, certain trusts, and certain tax exempt entities. 100 max (generally). One class of stock limitation. No restrictions. Entity Level California Taxes Gross receipts fee, unlike state law partnerships. $800 minimum. Minimum franchise tax of $800 or 1.5% taxable income. 8.84% corporate rate applies, or $800 minimum franchise tax. Option Plans, NSOs, ISOs Employees & consultants can be given options to acquire LLC interests, but such options are generally more complex, and cause §704(b) challenges. ISOs not available, but profits interests generally superior to ISO. ISOs commonly granted to employees. NSOs may be granted to employees, consultants, and advisors. ISOs commonly granted to employees. NSOs may be granted to employees, consultants, and advisors. 1. Choice of Entity (Assuming Domestic Entity) 4
  5. 5. LLC (not taxed as corp) S Corporation C Corporation Status Change on Transfer of Interests If taxed as partnership, LLC terminates for tax purposes on transfer of 50% or more of capital and profits in 12 months. Can convert between DRE and partnership on transfer No termination of entity on transfer of interests, except for election termination on transfer to ineligible shareholder. No termination of entity on transfer of interests. Treatment of Foreign Owners Foreign members subject to US tax on their share of effectively connected income of LLC; branch profits tax may apply. Foreigners cannot be shareholders of S corporation. Foreigners are subject to withholding tax on dividends from US corporation, subject to treaty rate or exemption. Foreign Individual Owners – Federal Transfer Taxes Unclear. N/A. Foreigners cannot be shareholders of S corporation. Corporate stock may be gifted tax free. U.S. corporate stock will be part of taxable estate, however. Conversion to Another Entity May generally be incorporated tax free, but see discussion herein. Conversion between partnership and DRE can cause tax (e.g., investment company rules). Can convert tax-free to C corporation by revoking election; likely to be taxed on converting to LLC. Can convert to S corporation by making election (built in gains tax may apply to later dispositions of appreciated property). Conversion to LLC likely taxable. Taxes on Sale or Liquidation One level of tax, generally capital gain except for amount allocable to certain assets. “Flowthrough” of international tax characteristics to foreign seller (including ECI). One level of tax on sale of stock or assets, generally capital gain on stock sale. No 754 election, decreasing desirability of stock sale to buyer. Potential double tax. Corporate tax on sale of assets. Shareholder level tax on sale of stock or liquidation. Sales by foreign shareholder likely not U.S. taxed. 1. Choice of Entity (Assuming Domestic Entity) 5
  6. 6. C Corporation (If Qualifying for QSBS) • 35% corporate income tax • 0% on shareholders if qualifies for QSBS • Subject to limitations ($10 million or 10 times the taxpayer’s adjusted basis) • Exit: QSBS not available in asset sale (nor, likely, deemed asset sales) S Corporation • Not subject to corporate income tax • Up to 39.6% on shareholders • Exit: can choose between stock v. asset sale 1. Choice of Entity - Qualified Small Business Stock GENERAL REQUIREMENTS  Original issue.  Five-year holding period.  100% post- Sept. 27, 2010.  $50 million Gross Assets Test.  Active Business Test.  No significant redemptions. Note: California does not follow federal income tax treatment of QSBS under § 1202. 6
  7. 7. 1. Choice of Entity – C Corp QSBS Better than S Corp? QSBS C-Corp S-Corp Assets Assets VS. (From seller’s view) Answer: Depends! Compare QSBS tax savings to S corp asset sale’s higher pre-tax FMV Tax Savings Favor QSBS Stock Sale •0% rate for QSBS sold (unless gain exceeds threshold) •20% rate for capital assets from S corp (likely no SECA, NIIT) •39.6% rate on OI assets from S corp •1.5% CA tax on net income Pre-Tax FMV Favors S Corp Asset Sale •Buyer should pay extra to buy S corp assets, and thereby get value of cost recovery •Value of cost recovery can be high, if fast rate, low future value discount •S corporations generally have only one layer of tax in asset sale Note: California does not follow federal income tax treatment of QSBS under § 1202. 7
  8. 8. 8 Meet Material Participation Test? YES NO SECA Tax Applies? NIIT Applies? SECA Tax Applies? NIIT Applies? Salary of shareholder of S corporation Yes No Yes No Distributive income of shareholder of S corporation No No No Yes 1. Choice of Entity – Self Employment Tax and NIIT
  9. 9. 9 S Corporation Shareholder /Employee Wage – subject to SECA tax Distribution – no SECA tax • No NIIT because shareholder engaged in active trade or business 1. Choice of Entity – Self Employment Tax and NIIT
  10. 10. 2. § 305(c) Proposed Regulations Change/ clarification Current rules Proposed rules Amount of deemed distribution The value of the additional shares to which the convertible instrument holder now entitled The increased value of the conversion privilege (compared to what instrument would have been worth if no adjustment) without regards to potential future adjustments. Timing of deemed distribution Unclear Earlier of date of adjustment, or date of distribution giving rise to deemed distribution. Withholding rules Unclear Must withhold. New rules must be followed issuer which, if followed, cause withholding agent to need to withhold (with special timing rules for when withholding is due by). Cash to withhold comes from other distributions on instrument; sale of instrument; use of assets/income held for beneficial owner; direct from beneficial owner. 10
  11. 11.  PIK Dividends Taxed to the extent of E&P: ‒ § 305 (b)(4): distributions ‘on’ preferred stock. ‒ § 305 (b)(5): distributions ‘of’ convertible preferred stock ‒ § 305 (b)(2): cash to some, increase in proportionate interest to others  Convertible Preferred Stock Can be treated as deemed dividend under disproportionate distribution rule. • If conversion ratio of class of stock changes over time, this can cause disproportionate distribution because it can cause classes to disproportionately increase interests in assets or E&P of corp. Treas. Reg. § 1.305-3(e), Ex. 6: Corp, Class A and B stock only • Class A has yearly cash dividends • Class B converts into Class A at different rates over time (see table to right) • Result: Class B gets .05 shares of Class A deemed dividend per year 2. § 305 Applied to Common Startup Scenarios Year Conversion Ratio 0 1 Class B : 1 Class A 1 1 Class B : 1.05 Class A 2 1 Class B : 1.10 Class A N 1 Class B : (1 + .05*N) Class A 11
  12. 12.  Unreasonable Redemption Premium • “Mandatory Redemption” or Redemption more likely than not to occur* • “Unreasonable “  Safe Harbor (before 1990, abolished) - 10% of issue price - Not redeemable for five years  OID De Minimis Rule (after 1990) - 0.25% of the redemption price * complete YTM • Amount  Difference between the redemption premium and a reasonable call premium (before 1990)  Entire Amount of the redemption premium (after 1990) • Timing  Deemed to be constructively received on the last day of each taxable year during the period (before 1990)  “Economic Accrual Rule” (after 1990) ‒ Daily portions of the premium must be included in each accrual period under the OID rules  Accruing Dividends • “Deemed distribution” because change in redemption price resulted in an increase in the shareholder’s proportionate interest of the issuing corporation. Prop. Reg. §1.305-7(d)(1)(ii) 2. § 305 Applied to Common Startup Scenarios 12 * Except that Economic Accrual Rule does not apply if the premium is solely in the nature of a penalty for premature redemption. Treas. Reg. § 1.305-5(b)(3)(i).
  13. 13. 2. § 305 Applied to Common Startup Scenarios  Pay to Play Provisions • An investor must keep “paying” (participating pro rata in future financings) in order to keep “playing”(not have his preferred stock converted to common stock) in the company. • Sample language of Pay-to-Play ‒ “In the event of a Qualified Financing . . . shares of Series A Preferred held by any Investor which is offered the right to participate but does not participate fully in such financing by purchasing at least its pro rata portion as calculated above . . . will be converted into Common Stock.”  Any §305 Issue with Pay-to-Play? • Not an actual stock distribution, so §305(c) test must be satisfied. • Perhaps could be characterized as a recapitalization following plan to periodically increase paying shareholder’s proportionate interest in assets or E&P, triggering §305(c). Reg. § 1.305-7(c)(1). • But really this doesn’t seem to cause a CRA; it just forces a conversion the shareholder might not want. 13
  14. 14.  Issue 1: For §351 nonrecognition, stock must be for “property” not “services” • Intangible property or services? • Also, be careful of cross-border §351s  Issue 2: §351 plan of contribution, and late founders contributing property • Issue: Cannot get 80% control group over OldCo • Solution: Incorporate and merge 3. Starting Capital Issues Corp. Property (?) SH Stock NewCo Property Late SH Stock TIME NewCo OldCo 14
  15. 15.  Issue 3: Corporate capital shifting • Taxation: Unlike partnerships, not taxable unless §305 triggered (or recharacterized in accord with substance) • Actually Quite Common: Frequently occurs; e.g., preferred stock with liquidation preference higher than contribution • Valuation: When preferred stock issued, people often value common stock by value of what it would receive in liquidation; this often drives common stock value to $0. But: liquidation value =/= fair market value!  Issue 4: Note-alternative and alternative convertible note securities • Note alternatives: Agreements that convert (perhaps for additional compensation) into equity of company on close of financing transaction. No interest or maturity date. • SAFE (Simple Agreement for Future Equity) • KISS (Keep It Simple Security): • Alternative convertible note: Mandatory convertible debt: Debt with a mandatory conversion into stock at a point in time in the future • Don’t directly value company; may provide cleaner cap table • Tax treatment – see §305(c) and section on stock rights for more 3. Starting Capital Issues 15
  16. 16.  Issue 5: Vesting vs. stock grant for founders • Fixed split versus dynamic split (discussed in following slides)  Issue 6: Series FF stock to get founders liquidity without compensation • Basics: We want founders have rights to sell their shares in financing rounds • Business challenge: Investors want preferred stock, not founders’ common; required redemptions and structuring to get around • Tax challenge: Risk of disguised compensation if structuring implied an overly high value to Founders’ common stock • Solution: Founder’s stock is essentially common convertible to preferred  Issue 7: Convertible debt for S corporations • Be careful not to trigger second class of stock rule! • Cannot be equity under general rules, and cannot be call option treated as second class of debt 3. Starting Capital Issues (Including Dynamic Split) 16
  17. 17. 4. Dynamic Split Models – General Concept • Traditional fixed-split model: Equity given based on anticipated contributions. • Dynamic-split model: Equity given based on actual contributions. • Inputs to dynamic-split model: The dynamic model assigns a relative FMV weight to various contributions from each participant, and contributions put into model:  Time spent working  Intellectual property  Commissions  Cash  Facilities  Equipment and Supplies • Outputs: Depending on the relative weighted contributions of each team member, that member is allocated a corresponding percentage of outstanding equity. – On “split,” members could return old equity, or be given new equity, to ensure each member gets appropriate percentage of company. 17
  18. 18. Grunt Fund Source: http://www.slicingpie.com/the-grunt-fund-calculator/
  19. 19. Grunt Fund Detail Source: http://www.slicingpie.com/the-grunt-fund-calculator/
  20. 20. 4. Dynamic Split Models – Tax Issues and Planning  Potential taxation: Stock for services (§83), repeated contributions of property (arguably not under §351) • Even worse, equity split is on some future date (when the business could have some real value).  C-Corporation Solution: • At start of company, all participants are granted a certain number of shares of Restricted Stock. • Participants make 83(b) election immediately to recognize ~$0 taxable income, when company worthless. • Vesting conditions: You only keep those shares such that you get your appropriate percentage under model. • Thanks to §83(b), participants will not need to pay taxes when Grunt Fund “split” occurs at some future date. • 305(c) CRA-type issues appear unlikely to trigger. 20
  21. 21. 5. Stock Rights – Classic Investment Types Tax Consequences Convertible Debt Warrant Timing No tax upon conversion. No tax upon exercise; Holder may recognize loss if the warrant lapsed without exercise. Basis (assuming no exercise price) Holder has the same basis in the stock as he had in the convertible debt. The purchase price of the warrant is included in the adjusted tax basis of the stock purchased by exercising the warrant. Holding Period of Stock Depends on manner of “exercise” The holding period of the stock will include the holding period of the debt instrument exchange. §1223 (1); Rev. Rul. 72-265 Holding period of the stock begins on the day that the warrant is exercised. §1223(5). (Secondary sources agree §1223(5) is not applicable to convertible debt). If the convertible by its terms requires a additional cash payment on exercise, the investor takes a split holding period. Rev. Rul. 62-140 If the warrants are exchanged for stock (other than NQPS) in a recapitalization or other reorganization under § 368, the holding periods of the warrants tacks on to the holding period of the stock acquired (because warrants are treated as “securities” under § 354). OID Issue No OID on the issue of convertible debt, assuming proper structuring of note’s interest payments. An investment unit (a note issued with a warrant) likely to have OID because part of the purchase price will be allocated to the warrant, creating a disparity between payment on maturity and issue price. 21
  22. 22. 5. Stock Rights – Classic Investment Types 22 • Conversion Discount v. Warrant in Convertible Note Financings 20% Warrant Coverage 20% Conversion Discount Amount of Convertible Note $100,000 $100,000 Qualified Financing Price Per Share $1.00 $0.80 Number of Shares on Conversion 100,000 125,000 Number of Warrant Shares 20,000 N/A Total Shares 120,000 125,000 LTCG on the Extra Shares? No Yes
  23. 23. 5. Stock Rights – Newer Investment Types Tax Treatment Note Alternatives (SAFEs, KISSes) Mandatorily Convertible Debt Potential Tax Treatment as Equity? Like penny warrant, could be deemed exercised from day one depending on certainty of exercise. If the conversion occurs fairly soon and is certain, and its performance in the debt/equity factors, there is a chance it could be classified as preferred equity. Potential Tax Treatment as Warrant? Probably the best analogy; SAFEs and KISSes are essentially investment stock options exercisable on certain events, rather than at certain times. Low; the distinction between convertible debt and regular stock rights under §1223(5) is generally respected. Would be hard to maintain this distinction if convertible debt becomes treated as warrants. Potential Tax Treatment as Convertible Debt? Low; the distinction between convertible debt and regular stock rights generally respected. See §1223(5), discussion to right. If conversion reasonably far into future and federal tax indicia of debt are generally positive, a likely outcome. But see risks below. Other Risks? Relatively untested tax treatment. Subject to §163(l), denying deductions if substantial amount of principal/interest is either (1) to be paid or converted to equity, or (2) valued by reference to equity. 23  Increasingly, alternative equity derivatives are being used to invest, but their tax status is often uncertain  This table discusses likely tax treatments
  24. 24. 5. Stock Rights – Incentive Stock Options (ISOs) Event Employee Tax Employer Tax Grant None None Transfer of ISO Not allowed except on death n/a Cancellation of ISO Consideration for cancellation is OI Withhold on OI amount; take deduction for compensation Lapse of ISO No loss None Exercise Note: No §83(b) allowed except for AMT purposes None; basis will equal exercise price EXCEPTION: AMT inclusion on the amount that would create OI on a disqualifying disposition None Disqualifying disposition of stock Note: If this is likely, use an NSO instead to get §83(b) treatment, avoid AMT hassles OI = ISO FMV at time of exercise minus exercise price; get basis credit for OI for computing LTCG LTCG on remaining gain Withhold on OI amount; take deduction for compensation Qualifying disposition of stock LTCG n/a Modification, extension, renewal Treated as new grant of stock option; re-test FMV, etc. at time of modification to option is not NSO See “Grant” above 280G Payment in nature of compensation, even though no income from it See 280G 24
  25. 25. 5. Stock Rights – Simulated Options Using Notes  Idea: Instead of option on stock, employee buys stock now using a note payable over time.  Taxation: Depends on note  If nonrecourse, may be treated as an option depending on three factors: § 1.83-3(a)(2)  (1) the type of property involved (here, stock);  (2) the extent to which the risk of loss on transferred property was transferred to buyer; and  (3) the likelihood that the purchase price will be paid  The degree to which note is recourse enhances the likelihood of transfer being respected as an actual sale  Still do §83(b), as §83 may apply even to sales at FMV to an employee  Forgiveness on notes will generate income to buyer  §409A should be avoided if note amount reflects FMV  Theory and stakes:  In a nonrecourse note, can just walk away and not pay. Economically, much like not exercising  If treated like option, not a “transfer” of property at time of sale. No §83 tax until exercise; no §83(b) on date of sale 25
  26. 26. 5. Stock Rights – Other Compensatory Types Other Compensatory Types  Employee Stock Purchase Plans (ESPPs) – Uncommon in startups  Restricted stock  Restricted stock units (RSUs)  Stock appreciation rights (SARs)  Phantom stock 26
  27. 27. 5. Stock Rights – California Residency of ISO • Do you have taxable income in CA if you exercise an ISO while a CA resident and later sell the stock while a nonresident? 27 Character of income CA taxable? AMT adjustment? Qualifying Disposition Sale of Intangible Property No Yes Disqualifying Disposition Compensation for Service (treated like NQSO) Yes Yes, if dispose and exercise in different years
  28. 28.  Contingent allocation issues • No clear guidance; these likely fail §704(b) economic effect, and it isn’t even clear how to reallocate in accord with PIP. • What is the issue? If allocations are given before full vesting and exercise, there’s a chance the capital account could be forfeit. Until no chance of forfeiture, no guarantee of liquidation in accord with capital accounts, and partner’s interests unclear.  Capital shift • Capital shift generally occurs when a member with a capital interest agrees to forgo part or all of its right to proceeds on liquidation of the partnership. A capital shift could also occur when a restricted interest vests, or when a preferred interest is converted into a common interest. • Taxable for the member receiving capital; uncertain taxation for the transferring members when an appreciated capital interest is transferred.  Profits interests • Rev. Procs. still valid; will be amended to no longer cover profits interests issued in conjunction with a partner foregoing “substantially fixed” compensation amounts. 6. Taxation for Compensatory Partnership Interests 28
  29. 29. • Start-ups started as LLCs may want to or need to convert into a corporate form at a later point because:  Venture capital investors more comfortable with corporate form  Potential IPO (but UP-C increasingly popular alternative)  Availability of Section 368 reorganization on exit  ISOs  General increased liquidity  Qualified Small Business Stock exemption ‒ Issuance of stock in a C corporation on incorporation of an LLC may qualify as QSBS stock ‒ Stock held in C Corp following termination of S Corp election does not qualify because stock was not issued in a qualifying corporation • Methods of incorporation: The IRS has approved three methods of incorporation Rev. Rul. 84-111 1. Assets Over 2. Assets Up 3. Interests Over Can combine assets over and assets up. See Regs. §1.708-1(d)(5) Ex. 7. 7. Incorporation of an LLC 29
  30. 30. • Method 1: Assets Over. Old LLC transfers all its assets and liabilities to the newly formed Newco in exchange for the stock in the Newco first, and then distributes Newco stock to LLC Members in liquidation.  Assume transfer satisfies Section 351.  Old LLC defers tax by taking a carryover basis and holding period in the stock (adjusted for liabilities assumed by Newco).  Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain recognized by Old LLC).  LLC Members take a substituted basis in the stock equal to their basis in the membership interests (adjusted for liabilities assumed by Newco and any gain or loss recognized in the transaction) but will take a carryover holding period in the stock. 7. Incorporation of an LLC 30
  31. 31. • Method 2: Assets up. Old LLC transfers all its assets and liabilities to LLC Members in liquidation first, and then LLC Members contribute assets and liabilities of Old LLC to Newco in exchange for Newco Stock.  Assume transfer satisfies Section 351.  LLC Members take a substituted basis in the assets equal to their basis in the membership interests (adjusted for any gain or loss recognized in the transaction) but will take carryover cost recovery and holding periods in the assets.  LLC Members take a carryover basis and holding period in the stock (adjusted for liabilities assumed by Newco and any gain or loss recognized in the transaction).  Newco takes substituted basis in the assets equal to the LLC Members’ bases in their membership interests (adjusted for any gain or loss recognized in the transaction) but will take a carryover holding period and cost recovery in the assets. 7. Incorporation of an LLC
  32. 32. • Method 3: Interests over. LLC Members transfer their Old LLC interests to Newco in exchange for Newco Stock first, and then Old LLC liquidates, but treated as asset transfer to Newco.  Assume transfer satisfies Section 351.  LLC Members take a substituted basis in the Newco Stock equal to their basis in the membership interests (adjusted for any gain or loss recognized in the transaction and liabilities assumed by Newco) and will tack the holding periods of their membership interests to the holding period in Newco Stock.  Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain recognized by LLC Members). 7. Incorporation of an LLC 32
  33. 33. • Debt Issues  Negative capital accounts: ‒ Debt in excess of basis. ‒ There may be a taxable gain where liabilities assumed exceed basis. Rev. Rul. 68-55. ‒ Partners could consider assuming some of the debt or contributing additional capital.  Debt Shifting: ‒ Applicable to “Asset Over” Incorporations ‒ Transfer of labilities from the LLC to the corporation is a deemed distribution by the LLC to its members, reducing the members’ basis in their LLC interests. ‒ May result in taxable gain if there is boot i.e., total labilities exceed total basis. §752(b); Treas. Reg. §1.752- 1(e).  “No Net Value” rules: ‒ Transferor must surrender net value and receive net value for a contribution to qualify for nonrecognition under §351. Prop. Reg. 1.351-1 ‒ FMV of the assets transferred must exceed the amount of any liabilities of the transferor assumed/satisfied by the transferee. ‒ If the LLC is insolvent, then no net value is transferred in the deemed exchange and the requirements of section 351 are not met. 7. Incorporation of an LLC 33
  34. 34. • As a general rule, non-discretionary compensation plans which will be paid in subsequent tax years are subject to §409A. • Many exceptions apply, which take payments out of §409A: – Short term deferral (certain to be paid within certain time window following final vesting condition) – Most compensatory equity rights, provided certain requirements met – Qualified plans • If subject to §409A, compensation plans must have the following features, or will be subject to acceleration and penalty tax rates: – Payments must be scheduled and generally paid on or within a set time or time window anchored on a “permissible payment event”, e.g., change-in-control, specified date, death . . . – Form of payment (lump sum or installments) and time of payment must be specified – Election to defer compensation must be done by employer or (occasionally) employee timely every year 8. §409A: Basic Analysis 34
  35. 35. • Deferral of founder salary until financing round occurs – Can always avoid issue by requiring worker be employed at time of financing round to get payment • Issuance of stock rights to employee prior to beginning services – Current final regulations: Service provider must provide services to issuer or related entity on date of grant to be eligible for stock right exceptions – Proposed regulations: Also OK if service provider reasonably expected to, and does, provide services to issuer/related entities within 12 months of grant • “Company is too new to need a §409A valuation for issuing options.” – No, it probably isn’t; safe harbor is very helpful 8. §409A: Common Tax Issues Different views on transaction Tax effect Vesting occurs at time of financing Short-term deferral, or objective installments under 1.409A-3(i)(1) Already vested due to high likelihood of event Violation of 409A (financing round not permissible event) 35
  36. 36. 36 • The Differences in Tax Treatment Employee Business Owner Independent Contractor 9. Employee vs. Independent Contractor Issues
  37. 37. 37 Employee Business Owner Independent Contractor Tax Income tax Yes Yes Yes Self-employment tax No (withholding instead) Yes (generally) Yes (generally) Filing How income is reported Form W-2 Schedule K-1 1099-MISC or receipts How taxes are paid Employer withholding Quarterly Estimated Taxes Quarterly Estimated Taxes Form included in tax return Form 1040 Form 1040 Schedule C or Schedule C-EZ Schedule SE Form 1040 Schedule C or Schedule C-EZ Schedule SE 9. Employee vs. Independent Contractor Issues
  38. 38. 38 Employment Type Employment Factors Employee: Behavioral Control: The company or business controls the work you do and how the work is performed (i.e. what tools to use, what assistants to hire, when to purchase supplies or services). You also receive training and extensive supervision. Financial Control: The company has the right to direct and control all business and financial aspects of the job. Type of Relationship: It's expected to be permanent (or at least relatively long-term). You are also given employee benefits (insurance, pension, paid vacation, and sick pay). The services you provide are a key aspect of the regular business of the company. Self Employed: • Business Owner • Independent Contractor Behavioral Control: You direct and control your own work. Financial Control: You have the right to direct and control the business and financial aspects of your job. You may also have unreimbursed business expenses, invest in the facilities, equipment, or tools used in performing your job, make your services available to the open market, set your own rate and prices for services, taxes are not withheld from your pay, or have the possibility of incurring a loss. Type of Relationship: The services you provide are not a key aspect of the regular business of the company. The relationship may not be permanent and the company does not give you employee benefits. 9. Employee vs. Self-Employed: Factors
  39. 39. What if I’m Still Not Sure? File Form SS-8 with IRS: Determination of Worker Statutes for Purpose of Federal Employment Taxes and Income Tax Withholding
  40. 40. 10. Debt-Equity Regulations and S Corporations Proposed Debt-Equity Regulations  The Proposed Regulations would: ‒ Treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes ‒ Authorize the Commissioner of the IRS (the Commissioner) to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes ‒ Establish extensive documentation requirements in order for certain related party interests in a corporation to be respected as indebtedness for federal tax purposes  If finalized, shareholders may find their company’s S corporation status has terminated due to debt to an ineligible shareholder being recharacterized into equity  Arguments exist that such debt should not be election-terminating second class of stock:  May be eligible for straight debt safe harbor in certain situations, which applies even to debt recharacterized as equity  Debt generally does not create a second class of stock if no intent to avoid tax; arguably, this should still apply even after recharacterization  Senate Finance Committee Chairman Orrin Hatch, along with other Senators from the Senate Finance Committee, has issued two letters to the Department of Treasury, requesting regulations to clarify how the proposed regulations would apply to small business owners. 40
  41. 41. The Innovation Network supports companies focused on creating new technologies for the ag and food industries Royse University: Providing business, tax, technology and personal finance ideas to founders and executives. Royse Law Presents: Supporting the Tech and legal community through events, networking, and webinars Royse Law Incorporator: Incorporate your company the Silicon Valley way. RoyseLawIncorporator.com RoyseUniversity.com RoyseAgTech.com RoyseLawPresents.com
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