The choice of entity questions is one that is often faced by entrepreneurs. Although each form of entity has its advantages and disadvantages, one advantage of a C-Corporation that often is not discussed is the potential tax savings an angel investor may enjoy by investing in a startup that is operating as a C-corp. Informed angel investors will certainly be aware of the enactment of Section 1202 of the Internal Revenue Code that was put in place to encourage individuals to invest in small business and to provide such investors some relief from the risks they bear by investing in early stage companies. Section 1202 allows individuals to exclude a portion of any gain realized on the sale of “qualified small business stock.”  For a more complete explanation of this concept see the article here.

You and your cofounders have formed your entity, issued equity and agreed on vesting terms for that equity.  Have you let the IRS know about it?

Wait, what?

That’s right.  If you’re like most startups, your founders received restricted equity that is subject to vesting and company buyback rights.  While this arrangement helps keep founders’ interests aligned, it can lead to nasty tax consequences for unwary entrepreneurs. 

Under the IRS’ default rules, founders recognize income as their equity vests in an amount equal to the value of that equity at the time of vesting over the price the founder paid for that equity.  Thus, if your startup (worth pennies at the time of formation) takes off like a rocket and lands a venture financing at a multi-million dollar valuation in year two, you could face a devastating tax bill as a result of the increase in the value of your stock.  And to make matters worse, you may not even have the funds to pay those taxes, as your founder stock is likely illiquid. 

How can entrepreneurs avoid this trap?  By making an 83(b) election and filing it with the IRS within thirty days after the date of issuance.  This thirty-day deadline is nonnegotiable.  Miss it?  You’re out of luck.   As a young startup you’ll probably screw up a lot of things—unfortunately, this is one area where there’s no room for error.

By making an 83(b) election, you’re telling the IRS that you’d liked to be taxed now as opposed to when your equity vests.  Since the price you paid for your founder equity was probably close to what it was worth at formation (i.e., not very much), you probably won’t face much of a tax consequence, if any.   Thus, we generally recommend that entrepreneurs make 83(b) elections when they receive restricted equity subject to vesting.

Last night I attended the 9th LaunchUp event at Thanksgiving Point where BTJD and I were invited to give a 10 minute presentation focused on common legal issues that entrepreneurs face with their early stage business.  Several people asked me to post my slides, so here they are:

Legal Presentation starts at minute 16:00.