Category: Corporations; Compensation &
Employee Benefits Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com As I understand it, a corporation (which I will call ABC) was recently formed by three individuals, Messrs. A, B, and C. ABC will elect S corporation status for the stub period from inception to December 31, 1996. ABC will initially be capitalized with $30,000 in cash from Mr. A with another $70,000 to be contributed by A in 1997. For that contribution, A will received 42.5% of the stock of ABC. The other two incorporators, B and C, will receive 42.5% and 15% of ABC's stock, respectively. B and C are not required to contribute to the capitalization of ABC. The stock issued to A, B, and C will be no-par stock. The issue you raised is the possible tax consequences to B and C. Obviously, they are receiving valuable consideration, the stock of ABC corporation, without a concomitant obligation to part with anything of value. In my opinion, this is a textbook case of receiving stock for services. I would assume that the only reason for giving stock to B and C is to secure their services or business contacts or something of that sort. Clearly the ABC stock they will receive has value, notwithstanding its status as no-par stock. As I understand it, one of the taxpayer's advisors suggested that using no-par stock avoids the compensation element to B and C. I fail to see why. It is very well settled that the fair market value of property issued in exchange for services is the measure upon which the compensation element is based. See IRC Section 83. Be aware that typically stock issued for services is restricted as to transferability. In other words, there is usually a vesting period, for obvious reasons. Section 83 provides that the property recipient is taxable only when the restrictions lapse and at the value of the property at the date the restriction lapse. This latter valuation point is very important. I presume the value of ABC is largely speculative at this time. Presumably, the value of the stock should reflect only the value of the cash initially contributed. (See the discussion of valuation below). Suppose ABC proves to be successful. It is quite possible that ABC stock would have a very substantial value at that point. If the restrictions lapse at a time when ABC stock is very valuable, Messrs. B and C could face a very significant tax obligation without any source of liquidity with which to pay the tax. IRC Section 83(b) provides a way around this problem. If B and/or C so elect, they could recognize as taxable compensation income the fair market value of ABC stock when they receive it. This is a positive election that must be made within 30 days of the issuance of the stock. The timing is absolutely critical. When the restrictions lapse, nothing happens for tax purposes. In addition, if the stock is subsequently sold, the difference in basis (the compensation amount) and the selling price is capital gain. Without an 83(b) election, the whole amount of income at the time the restrictions lapse is treated as compensation income. ABC company is entitled to a compensation deduction whenever B and/or C recognize the corresponding amount of compensation income. In addition, ABC must withhold payroll taxes. This is by no means intended as a complete treatise on Section 83. I strongly advise you to look into this further on your own. If I can be of assistance by providing you with research materials, please let me know. In addition, we discussed the valuation of the stock received by B and C. I have since had second thoughts about our conversation. Take B for instance. I suggested that B's stock should be worth 42.5% of the cash contributed by A. On reflection, this makes no sense. I think A would feel very strongly that his stock is worth no less than the amount he will ultimately pay, some $100,000. How then can we argue that B's stock (which is identical to stock issued to A) is only worth 42.5% of $100,000? This makes no sense to me. I look forward to any thoughts you might have on this matter. |
