The primary financial incentive for a key employee of a startup business is often the prospect of a large financial benefit when the company goes public or is sold to another company for cash, equity, or both. In such situations, the employee will want to structure equity participation in the startup in a way that will allow the employee’s “windfall” to be taxed at the favorable rates applicable to long-term capital gain, rather than as ordinary income. Although rate changes in recent years, including the imposition of a 3.8 percent (Obamacare) tax on “net investment income,” have reduced the difference between the tax rates applicable to the two categories of income, the potential difference in rates remains sizable and does not appear likely to disappear in the near term.1
A tension between risk and reward is implicit in the tax planning for such employees. The acquisition of stock—as distinguished from options or other equity-flavored instruments—as early as possible in the lifetime of the venture provides the maximum potential for characterization of any ultimate gain as long-term capital gain. (Such an acquisition will often be coupled with an election under IRC §83(b), further discussed below, if the stock is subject to vesting conditions.) However, a purchase of stock by an employee may involve a high level of financial risk, in that the business may fail with the complete loss of any consideration paid for stock. Further, even though an acquisition of stock under compensatory circumstances may result in ordinary income, to the extent that the value of the stock, at the relevant date, is more than the amount paid, a later forfeiture or other disposition of the shares may result in a capital loss the usefulness of which is limited, or in no tax benefit at all.
