

Taxes for employee stock purchase in a startup - Advice? - joshhart

Hi all,<p>I'm about to join a startup as the first employee (besides the founder). As part of my package I will get equity. Additionally, we've talked about establishing a policy to transfer salary to equity each month.<p>I was wondering what the tax laws would be on this. If, for instance, I have a monthly income of $5000 and want to convert $2000 into equity, will I have to pay taxes for $5000 or $3000 of income?<p>What else should I know? From what I've heard, for this to even be possible we'd have to have an external valuation of the company's worth. Any good links or advice would be greatly appreciated.
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dennykmiu
I think everyone is giving you really good advise here so I am going to take a
different tact which is to look at this from the owner's perspective (i.e.,
the founder).

My guess is that he believes that he/she has invested quite a bit already and
that this is his/her company and not yours. He needs you as an employee and he
is treating you as such.

But he is not willing to pay you market value so he is deducting $2K from your
pay in exchange for a small piece of the company at an inflated price that at
the moment only he can justify.

What makes this one a brain-dead offer is that he is asking you to pay tax on
your monthly generous gift.

~~~
tptacek
I agree with your skepticism about the deal, but not because of taxes.
Handling the taxes in a situation like this is a pain in the ass.

The odds of any startup succeeding in any business climate (let alone ours) is
low. As employee #1 in the company, you'd want that $2k to be getting a
founder's multiple. I don't know what that number is, but my mind jumps to
5-10x. So each time you're getting $2k worth of stock, you want it backed with
a story that in 2 years makes you $10-$20k.

The question in this post doesn't contain any numbers (revenue, projections,
go-to-market, funding plans), which makes me think that conversation hasn't
happened yet with the founder. So what I think is, taking this deal is
basically shoveling $2k/mo into a black hole.

I've been in this exact situation twice. I accepted the deal both times. The
first time I came out about $20k behind where I would have been with straight
salary. The second time, my "investment" made a little better than 25x, which
set me up for my own first startup. So it's not like I think this is a rip-
off; I just think you're leaving too much up to chance.

Finally, I don't like how Denny is wording this response. $60k/yr is a healthy
pre-revenue startup paycheck. It's not rockstar comp, but it's not a rip-off
either. If you're getting solid W2 wages, I think it's hard to say that the
business "owes" you anything outside of what you can negotiate.

~~~
dennykmiu
But he is not getting $60K. He is getting $36K, or $18 an hour if he works
just 40 hours a week. I suspect he works at least twice that which basically
says that he will be working below minimum wage. My point is that he is being
treated as an employee and as an employee, he is being cheated.

~~~
tptacek
He's getting $36k if he takes the deal. We agree, he shouldn't take the deal.
We disagree that he's being cheated; right now, it just looks like a poor
deal.

~~~
dennykmiu
I think it is a poor deal not because of the money or the tax consequence. I
think it is a poor deal because he is being treated as an employee and not as
a co-founder.

Entrepreneurs often preceive their net worth based on how much effort they
have put in and not on how much more it will take to get to the end goal. So
it is not the details that made this such a bad deal but the assumption.

~~~
tptacek
He's not a cofounder. He makes 60k a year (or 36k, if he accepts a bad deal).
I'm pretty sure both of us have been bona fide cofounders with employees, and
that we both know the difference; we don't talk about our monthly paycheck,
because we eat last.

~~~
dennykmiu
joshhart: If you are still reading the comments, you need to decide if you are
a co-founder or an employee.

If you believe you are an employee, then structure a better deal that is more
fair which basically says that you are getting paid at market value ($3K now
and $2K as deferred compensation which is essentially a senior loan to the
company that the owner needs to pay you back in the future).

Then at the same time, negotiate a stock plan which you can purchase upfront
for just a few hundred dollars which the owner can buy back if you do not
perform.

However, my own advise is that being employee #1, you are essentially a co-
founder (because of the current down market, there isn't going to be much
upsides for a long long time).

~~~
joshhart
Hi Denny,

I appreciate the advice. Honestly, I believe myself to be an employee. I'll be
making a pretty decent salary and getting a few percent of equity upfront. The
founder has worked very hard on the produce for about 15 months or so. I
probably didn't give enough information earlier but I'm not sure exactly what
I can or can't say legally.

I also don't think I really understood how ESPPs worked before. We'd revalue
the company and I'd be able to purchase at a reduced rate. I don't think
that's a bad deal, especially for a product and monetization model I really
believe in.

~~~
dennykmiu
That sounds great. We are ALL on your side. Good luck.

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skmurphy
If you are paid in stock it's still taxable at the value assigned.In your
example a $3K salary and $2K of stock would be taxed at $5K. You are probably
better off paying for restricted stock at a very low price that reflects the
current state of the startup. In other words negotiate for your % of
ownership, pay for it now at "today's price" for the company (and execute the
83(b)), and have your stock subject to buyback restrictions that are on a
vesting schedule (such that your true ownership of that % may take three to
five years).

See [http://www.startupcompanylawyer.com/2008/02/15/what-is-
an-83...](http://www.startupcompanylawyer.com/2008/02/15/what-is-
an-83b-election/)

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aheilbut
You should work with a lawyer to do it right.

(Disclaimer: I'm not a lawyer, but just went through this process...) If the
company has no established value, then when it is incorporated the common
shares are assigned an arbitrary, very small par value (like 0.0001 cents
each).

The company then sells those shares to the founders. So if the company issued
5M shares, and you were going to get 20%, you'd write a cheque to buy 1M of
those shares from the company for $100, and that's exactly what they're worth
for tax purposes. If this is restricted stock (ie. subject to vesting) then
you need to make an 83(b) election within 30 days of acquiring the stock.

~~~
joshhart
To address a previous comment made, I will be getting some upfront equity.
This is more of an "incentive to reinvest in the company" kind of deal.

Referring back to my example - say I'm usually paid 5k/month but I decide I
only need 3k so I ask for 3k and X number of shares. Those shares are assigned
.0001 cents since the company has no established value so I now have $3020 in
income. Shouldn't I just have to declare $3020 worth of income and the shares
are now subject to capital gains?

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jojoleflaire
Make sure you learn about the rules around the 83(b) election for your stock.

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crhulls
The advice people are giving you is way too complex. Here is the simple
answer: Don't worry about taxes in this case.

1) An 83b is irrelevant for this problem (you aren't vesting over time, thus
there is no chance of a large increase in the share price before you get your
grant)

2) You _aren't_ getting $2000 a month in stock. You are getting what he is
saying is a fair equivalent of $2000 a month. You might have to report a
couple bucks a month in income to the IRS, but it will be negligible because
the real value of anything he gives you will be basically zero on paper

3) You pay taxes on the market rate of anything you get..keep that in mind.

4) If you really don't want to worry, don't get a stock or options grant, just
"purchase" your shares from the company. At a fraction of a cent each, the
shares are essentially free, so just write the guy a check. Since you bought
them you won't be taxed until you have a gain.

~~~
anamax
> 1) An 83b is irrelevant for this problem (you aren't vesting over time, thus
> there is no chance of a large increase in the share price before you get
> your grant)

How do we know that he is purchasing all his stock up front with no
restrictions?

If he is, he can quit now and get a job that pays him market rate while
keeping all the stock. Somehow I doubt that that's the case.

If he's purchasing stock each month (or getting the right to keep stock that
he's been granted, that is, repurchase rights are expiring), 83(b) is
relevant.

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gojomo
It's a little odd for a tiny private tech startup to be talking about monthly
stock purchases rather than a larger upfront grant (of options or stock) that
vests over time. The latter seems much more common.

You owe tax on income when it is received -- whether that income is cash or
stock. So in your 'for instance', you'd owe on $5K each month. It's as if they
paid you $5K cash, on which you owe taxes, and then you decided to buy $2K of
stock.

In many cases, you would rather pay for your full grant at the earliest
possible date, before your own sweat equity starts making the stock more
expensive. The company protects itself by having the stock subject to vesting
if you leave early -- but then you should make absolutely sure to do a prompt
"83(b) election" so that you don't owe taxes at each vesting increment.

A good startup lawyer could be telling the founder and you all this, and more.
If the plan is for this to grow big, and there will be other employees on
stock plans, doing it right is worth the cost.

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pj
[http://turbotax.intuit.com/tax-tools/tax-tips/investments-
an...](http://turbotax.intuit.com/tax-tools/tax-tips/investments-and-rental-
property/5595.html)

~~~
joshhart
I've looked at some stuff, but I don't know if there's any difference for a
startup. At a big company there is a specified market price - at a startup
without VC there isn't.

~~~
adam78
What percentage of ownership are you looking at as employee #1? What is the
industry range for this? Does it vary by how much capital and effort are
already invested by founders?

