What is qualified small business stock?
February 25, 2008
Under Internal Revenue Code Section 1202 , a taxpayer (other than a corporation) that recognizes gain from the sale or exchange of “qualified small business stock” held for more than five years may exclude 50% of such gain from gross income for regular income tax purposes. The amount of gain that may be taken into account for purposes of the exclusion is subject to a limitation equal to the greater of: (i) $10,000,000 (less previously excluded gain attributable to the disposition of other shares issued by the company), or (ii) 10 times the aggregate adjusted basis of the shares. In addition, a portion of the excluded gain is included in the calculation of alternative minimum taxable income.
Under IRC Section 1045, an individual may roll over proceeds from the sale of a qualified small business stock held for at least six months, when the proceeds are used to purchase qualified small business stock in another company. This effectively defers the tax due on any gain on the stock.
However, the maximum tax on long-term capital gains is 15% for most taxpayers and a 28% rate applies to gain on qualified small business stock. The effective tax rate after the 50% exclusion is 14%. Therefore, there is no substantial benefit to qualified small business stock unless the gain is rolled over into other qualified small business stock.
Qualified small business stock is defined in Section 1202 as any stock in a qualified small business issued to the taxpayer after August 10, 1993 in exchange for money or other property (not including stock), or as compensation for services. A qualified small business is a domestic C Corporation in which the aggregate gross assets of the corporation at all times since August 10, 1993 up to the time of issuance do not exceed $50,000,000. However, stock will not be considered to be qualified small business stock unless during substantially all of the taxpayer’s holding period the corporation meets certain “active business” requirements.
Stock issued by an S corporation does not qualify as qualified small business stock (even if the S election is later revoked), although subsequently acquired stock may qualify.
In general, gain from stock issued to “flow-through entities” such as partnerships and S corporations should qualify under Section 1202. However, the amount of the qualifying gain is limited to the interest held by the partner or S corporation shareholder on the date the stock is acquired. This limitation may be significant in certain venture fund settings when the general partners’ interests fluctuate over time.
Please note that certain redemptions, including (i) redemptions of stock from the holder of qualified small business stock (or a related person) and (ii) certain significant redemptions occurring within one year before or after a stock issuance may disqualify any newly issued stock.
[Note: please go ask your own tax advisors any questions about qualified small business stock because I will not answer technical questions in the comments.]
What is an 83(b) election?
February 15, 2008
Failing to make a timely 83(b) election with the IRS is something that could lead to disastrous tax consequences for a startup company founder or employee.
Founders typically purchase stock pursuant to restricted stock purchase agreements that allow the company to repurchase “unvested” stock upon termination of employment. Similarly, employees may “early” exercise options subject to the company’s ability to repurchase “unvested” shares upon termination of employment.
Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize income (the difference between fair market value and the price paid) until the stock vests. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock.
Typically, the purchase price for the stock and the fair market value are the same. Therefore, if an 83(b) election is made, there is no income recognized. Thus, a founder/employee should almost always make an 83(b) election. The benefits of an 83(b) election generally are starting the one year capital gain holding period and freezing ordinary income (or alternative minimum tax) recognition to the purchase date.
If the founder/employee does not make the 83(b) election, then he or she may have income at the stock “vests.” The income will be substantial if the value of the shares increases substantially over time.
For example, assume that a founder purchases stock for $0.01 per share (fair market value is $0.01) and the stock is subject to four year vesting with a one year cliff. The founder does not make an 83(b) election. At the end of the one year cliff, if the stock is worth $1.00/share, then the founder would recognize $0.99/share of income. As the remaining stock vests each month, the founder would recognize income equal to the difference between the fair market value and $0.01/share. In addition, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.
If the founder had made an 83(b) election, the founder would not recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date.
In order for an 83(b) election to be effective, the individual must file the election with the IRS prior to the date of the stock purchase or within 30 days after the purchase date. There are no exceptions to this timely filing rule. The last possible day for filing is calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. For example, if the stock is purchased on May 16, the last possible day for filing is June 15. The official postmark date of mailing is deemed to be the date of filing. The election should be filed by mailing a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his or her tax returns. If the election is mailed after the 27th day, the individual should hand deliver the letter to the post office to obtain an official date-stamp on the certified mail receipt. A copy of the election should be provided to the company, and another copy should be attached to taxpayer’s federal income tax return for the year in which the property is acquired.
What inspection and information rights does a stockholder have?
February 9, 2008
Most states allow stockholders to demand access to a corporation’s books and records, and a stockholder list, as long as the stockholder has a proper purpose and meets certain procedural requirements.
Delaware General Corporation Law Section 220(b) provides that “Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from … [t]he corporation’s stock ledger, a list of its stockholders, and its other books and records …”
A stockholder that wants to exercise inspection rights should probably engage an experienced attorney because a corporation can reject the request for failure to comply with procedural requirements.
If the corporation refuses to permit an inspection or does not reply to the demand within 5 business days, the stockholder may apply to the Delaware Court of Chancery for an order to compel such inspection.
One requirement for exercising inspection rights is a proper purpose for the demand. Section 220(b) provides that “[a] proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder.”
Delaware courts have held that the following purposes, among others, are proper: gather information prior to filing a stockholder derivative suit, communication with other stockholders regarding a solicitation of proxies, communication with other stockholders regarding a stockholder class action against the corporation, communication with other stockholders for the purpose of influencing management to change its policies, communication with other stockholders to encourage them to dissent from merger and seek appraisal, valuation of one’s stockholdings, and investigation of suspected mismanagement where some credible basis for the stockholder’s suspicions is shown to exist.
Courts have rejected inspections for purposes such as: gaining information to facilitate a tender offer when the stockholder has already been enjoined from pursuing a tender offer, valuing the company as a whole in order to determine whether to increase one’s bid in a tender offer, gathering information for use in a stockholder’s individual employment-related claims against the corporation, obtaining information to use to exert economic pressure upon a third party in connection with a labor union’s strike, or satisfying idle curiosity.
If a stockholder seeks to inspect only the corporation’s stock ledger or list of stockholders, the burden of proof is on the corporation to establish that the inspection if for an improper purpose. If the stockholder seeks to inspect the corporation’s books and records, other than its stock ledger or list of stockholders, then the burden of proof is on the stockholder to show a proper purpose.
A stockholder will be entitled to inspect documents that are essential and sufficient to the accomplishment of the proper purpose. The Court of Chancery may “prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper.” A stockholder may be required to execute a confidentiality agreement in order to exercise inspection rights.
Given that disgruntled stockholders can create problems by exercising inspection rights, companies should be careful about their stockholder base.
How do you calculate Delaware franchise taxes?
February 1, 2008
A corporation’s Delaware Annual Franchise Tax Report is prepared by Delaware calculating the corporation’s annual tax obligation using the “authorized shares” method, reflecting a very large annual franchise tax obligation for most corporations. However, use of the optional “assumed par value capital” method of tax calculation will typically result in a lower tax obligation than the amount shown in the “amount due” box online for the tax bill. A corporation has the option of using whichever method of tax calculation results in the lower tax. Explanation of the Delaware tax calculation methods are posted on the Delaware Division of Corporations’ web site as set forth below.
HOW TO CALCULATE FRANCHISE TAXES
All corporations formed in the State of Delaware are required to file an Annual Report and to pay a franchise tax. The Annual Report filing fee for all domestic corporations is $25.00. Taxes and Annual Reports are to be received no later than March 1st of each year. The minimum tax is $35.00 with a maximum tax of $165,000.00. Taxpayers owing $5,000.00 or more make estimated payments with 40% due June 1st, 20% due by September 1st, 20% due by December 1st, and the remainder due March 1st.
The Annual Franchise Tax is calculated based on the authorized shares method. Use the method that results in the lesser tax. The total tax will never be less than $35.00 or more than $165,000.00.
Authorized Shares Method
For corporations having no par value stock the authorized shares method will always result in the lesser tax.
- 3,000 shares or less (minimum tax) $35.00
- 3,001 - 5,000 shares - $62.50
- 5,001 - 10,000 shares - $112.50
- each additional 10,000 shares or portion thereof add $62.50
- maximum yearly tax is $165,000.00
For Example
A corporation with 10,005 shares authorized pays $175.00 ($112.50 plus $62.50)
A corporation with 100,000 shares authorized pays $675.00 ($112.50 plus $562.50[$62.50 x 9])
Assumed Par Value Capital Method
To use this method, you must give figures for all issued shares (including treasury shares) and total gross assets in the spaces provided in your Annual Franchise Tax Report. Total Gross Assets shall be those “total assets” reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company’s fiscal year ending the calendar year of the report. The tax rate under this method is $250.00 per million or portion of a million. If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $250.00.
The example cited below is for a corporation having 1,000,000 shares of stock with a par value of $1.00 and 250,000 shares of stock with a par value of $5.00 , gross assets of $1,000,000.00 and issued shares totaling 485,000.
- Divide your total gross assets by your total issued shares carrying to 6 decimal places. The result is your “assumed par”.Example: $1,000,000 assets, 485,000 issued shares = $2.061856 assumed par.
- Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par.Example: $2.061856 assumed par s 1,000,000 shares = $2,061,856.
- Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value.Example: 250,000 shares s $5.00 par value = $1,250,000
- Add the results of #2 and #3 above. The result is your assumed par value capital.Example: $2,061,856 plus 1,250,000 = $3,311 956 assumed par value capital.
- Figure your tax by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $250.00.Example: 4 x $250.00 = $1,000.00
NOTE: If an amendment changing your stock or par value was filed with the Division of Corporations during the year, issued shares and total gross assets within 30 days of the amendment must be given for each portion of the year during which each distinct authorized amount of capital stock or par value was in effect. The tax is then prorated for each portion of the year dividing the number of days the stock/par value was in effect by 365 days (366 leap year), then multiplying this result by the tax calculated for that portion of the year. The total tax for the year is the sum of all the prorated taxes for each portion of the year.
You may also use our Franchise Tax Calculator for estimating your taxes.
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