Sweat Equity: Tax Planning for Founders' Shares and Beyond
| Publication year | 1994 |
| Pages | 869 |
1994, April, Pg. 869. Sweat Equity: Tax Planning for Founders' Shares and Beyond
Organizers of new business enterprises are blessed with several choices for the legal structure of a new organization, including S and C corporations, general and limited partnerships, limited liability companies and business trusts. Most tax practitioners and business lawyers are well versed in the legal and tax attributes of these entities and effectively guide their clients through the choice-of-entity maze.
A far more subtle planning issue is how to reward the founders of new ventures with equity interests while at the same time minimizing their tax exposure. This article addresses the latter issue, describing the "founders' shares" technique for acquiring equity interests in corporations and the "profit interest" technique for awarding interests in entities taxed as partnerships.
Founders' shares are shares of common stock purchased for a minimal cash price by the founders or organizers of a newly formed corporation. Because the cash raised by this financing is not intended to fund the corporation's capital needs, outside investors subsequently are brought in to purchase the corporation's stock at prices substantially higher than the price paid by the founders. The outside investors typically assume a passive role and tolerate the dilution of their interests by the founders' shares based on their faith in the new venture's ultimate success.
The Internal Revenue Service ("IRS") has attacked this structure, asserting that the founders have purchased their shares at a bargain price and that the bargain should be taxed as compensation income.(fn1) In other words, the IRS asserts that a portion of the founders' equity interest in the corporation has been received in exchange for the founders' past or future services and, as such, is taxable upon receipt. Because this argument may reflect the reality of the arrangement in many respects, the founders must protect the integrity of their purchase price by separating the timing of the founders' purchase from the investors' purchase by contingent events.
The technique of separating the founders' purchase from the investors' purchase was successfully employed in Berckmans v. Commissioner.(fn2) Berckmans involved a business financing transaction similar to most founders' shares transactions. The taxpayer organized a new corporation to purchase a brewery. He contributed $1 per share for 61 percent of the corporation's initial stock. The balance of the stock was issued to the taxpayer's investment banker for the same price.
After these purchases, the taxpayer negotiated to buy the brewery, arranged debt financing and organized an underwriting group to do an initial public offering ("IPO") of stock to raise the equity necessary to close the purchase of the brewery. In the six weeks following the initial formation and capitalization of the corporation, the taxpayer completed all the negotiations and signed the necessary contracts. The corporation then issued additional stock in the IPO at $8.50 per share.(fn3) The taxpayer's 61 percent stock interest was diluted to approximately 7 percent.
The IRS attempted to value the taxpayer's stock at the IPO price, taxing as compensation the value in excess of the $1 per share purchase price. The Tax Court rejected the IRS's approach, holding that when the taxpayer acquired his $1 stock, less than two months before the IPO, the corporation had financial uncertainties and no ongoing business.
The Tax Court found that the value of the taxpayer's stock was no more than the price he paid. Accordingly, the taxpayer did not receive taxable compensation even though his stock substantially appreciated in value as a result of his services in closing the purchase transaction. The taxpayer in Berckmans effectively used the founders' shares technique to support the low purchase price of his sweat equity interest.(fn4)
If Berckmans demonstrates the highest in inspirational sweat equity planning, the facts in James v. Commissioner(fn5) illustrate just the opposite. In James,
the taxpayer was a builder, real estate promoter and developer. He entered into an agreement with a landowner for the construction and promotion of a rental apartment building to be owned by a newly formed corporation. The landowner agreed to contribute vacant real estate in exchange for one-half of the corporation's shares. In exchange for the other half of the corporation's shares, the taxpayer agreed to "promote the project" and to be responsible for the planning, architectural work, construction, landscaping, legal...
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