The document discusses tax issues related to startup companies. It begins by covering the choice of entity for a startup, comparing an LLC, S corporation, and C corporation. It notes tax implications of each including taxation of earnings, eligibility requirements for owners, and taxation of transfers. The document then discusses specific issues related to startups including section 305 regulations on convertible preferred stock, taxation of stock rights like convertible debt and warrants, and dynamic split models for allocating equity.

1. Tax Issues for
Startup Companies
Silicon Valley, San Francisco, Los Angeles
rroyse@rroyselaw.com
www.rroyselaw.com

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. 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. 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. 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. 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. 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
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
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. 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.  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.  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. 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.  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.  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.  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. 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. Grunt Fund
Source: http://www.slicingpie.com/the-grunt-fund-calculator/

19. Grunt Fund Detail
Source: http://www.slicingpie.com/the-grunt-fund-calculator/

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. 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. 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. 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. 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. 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. 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. 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.  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. • 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. • 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. • 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. • 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. • 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. • 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. • 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
• The Differences in Tax Treatment
Employee
Business Owner
Independent Contractor
9. Employee vs. Independent Contractor Issues

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
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. 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. 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. 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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