Sec. 83 risks when compensating founders in a new venture.

• Author: Beadle, Nate

The founders of a new venture are often entrepreneurs who have the ideas and relationships to start and create a successful venture, but not the capital to sustain and develop it. Venture capitalists, private-equity funds and public markets satisfy the needs of the new venture and its founders. However, whether at inception or at a later date, capital infusions are not without their tax pitfalls. When the founders, in exchange for bringing investors into their venture, receive a large equity interest in exchange for a relatively small capital contribution, Sec. 83 could require them to recognize substantial ordinary income. A common solution is the use of a partnership or limited liability company (LLC) and the issuance of profits interests to alleviate Sec. 83's effect. However, in many cases, the LLC does not enjoy the same access as corporations to the capital markets, so the Sec. 83 risks remain substantial for many start-up ventures.

Overview

In general, Sec. 83 applies to a transfer of property in connection with the performance of services. Stock issued in connection with services is compensatory and requires the recipient to recognize ordinary income, to the extent the value of the property received exceeds that of the consideration given; see Sec. 83(a). When stock received in a compensatory transfer is subject to a substantial risk of forfeiture, the receipt is taxable only when that risk lapses. However, the recipient will recognize ordinary income on any appreciation between the date of the initial transfer and the risk's lapse. The recipient may elect under Sec. 83(b), within 30 days from the date of the transfer, to be taxed in the year of transfer rather than waiting until the property is fully vested and recognizing the appreciation as additional compensation. If the issuance is not made in connection with the performance of services, it is capital in nature.

Performance of Services

For Sec. 83 to apply, the property must have been transferred "in connection with the performance of services" A transfer is subject to Sec. 83 whether in connection with past, present or future services; see Regs. Sec. 1.83-3(f). Neither Sec. 83 nor Congress has specifically addressed what constitutes a transfer in connection with the performance of services. The courts have generally held that Sec. 83 was intended to apply broadly; see Alves, 79 TC 894 (1982), aff'd, 734 F2d 478 (9th Cir. 1984). The Ninth Circuit has stated that "Congress made...