This tax scenario is not an uncommon one for entrepreneurs. At the outset of starting a business venture, there are several founders who wish to avoid legal expenses and to keep matters relatively informal. They prefer to wait for the venture to gain traction before investing time and resources in addressing legal formalities. Maybe they form a company but neglect to engage in necessary formalities or maybe they forego even forming a business entity at all.
Much to the delight of the founders, the venture develops rapidly and an opportunity materializes with a third-party investor for a cash infusion ($100,000 in our hypothetical) in exchange for equity (10% in our scenario). Perhaps at this point the founders resolve to form a corporation to formally house the business. There is a stark reality to this situation, however. The issuance of stock to the founding group representing the remaining 90% of the company comes with the tax liability due on $900,000 of income, despite receiving no cash.
While surprising and perhaps counter intuitive in many circumstances, generally speaking, stock in a corporation issued to stockholders in exchange for "sweat equity" is a taxable event whereby the receiving stockholders owe income tax on the fair market value of the issued stock. Ascertaining the fair market value in a small, privately held company typically leaves a lot of room for subjective judgment. However, at the time when a third-party investment is made, it is difficult to argue that the company valuation should not be pegged to the same valuation used in the cash raise. While the investor merely establishes a basis in his shares and owes no tax, the founders have received payment in exchange for services, a taxable event.
There are strategies that can be utilized to diffuse the tax problem described above. The cleanest is to consult with corporate counsel at the outset of a business venture, form an entity, and issue shares of the company early when they are likely worth zero, at least in theory.
Another way to mitigate the above situation is by issuing preferred stock to third-party investors that carry rights different from the common stock issued to the founders. Since preferred stock has repayment priority, the founding owners of common stock can argue that the valuation of their shares should be considerably lower. Additionally, in the instance where the founders formed a company but neglected to issue shares, an argument can be made that even if the stock is issued to the founders at the later date when the company structure is formalized, the valuation for determining the tax liability for the stock should be set at the time the founders started work on the venture. Presumably the stock had little or no market value at that time. While both strategies for mitigating the effects of an early-stage mistake are helpful and could ultimately sway the IRS if audited, neither is guaranteed to work.
Additionally, there are structuring alternatives that potentially can be utilized to alleviate some of the tax consequences. For instance, the tax treatment of issuing ownership interests in an entity taxed as a partnership, such as a properly structured limited liability company, may avoid the tax issues faced by the founders described in the hypothetical. Whether or not a limited liability company would be an appropriate business structure depends upon a number of factors. However, a "profits interest," which is available to partners of a partnership-taxed structure, may not be taxed upon receipt provided the assets of the company are booked up at the time of issuance so that there is no immediate gain to the recipient of the profits interests.
Of course, the easiest solution is to consult with a corporate attorney at the outset and avoid these headaches. While a stock issuance immediately at the outset of a business venture is still a taxable event, the minimal value of the stock results in minimal tax liability. The difficulty arises when the founders neglect to follow the formalities of issuing the stock early in the venture's existence and then later the company has significant market value.
Practically speaking, it is reasonable for entrepreneurs to want to first determine whether a venture will have long-term value before expending time and resources tending to various legal formalities. However, such an approach does come with risks, potential tax liability being one of them. Often times in hindsight, the relatively modest expenditure in the early life cycle of a business venture can seem exceedingly inexpensive compared to untangling the consequences of poor planning.