New Exemption for Sales of Restricted Stock

President Obama signed legislation this month that creates a new, explicit exemption for private resales of restricted and control securities. The legislation, contained in Fixing America’s Surface Transportation Act (the FAST Act), will make it easier for the holders of restricted stock to cash out their holdings, provided they sell only to accredited investors.

Here is an overview of the new exemption’s requirements:

  • The seller can’t be the issuer of the stock or a direct or indirect subsidiary of the issuer
  • Each purchaser must be an “accredited investor”
  • There cannot be any general solicitation or advertising
  • The stock must be part of a class of stock that has been authorized and outstanding for at least 90 days prior to the sale date
  • The stock cannot be part of an unsold allotment to, or subscription or participation by, a broker or dealer as an underwriter or a redistribution
  • The seller is subject to the “bad actor” disqualification
  • If the issuer is a non-reporting issuer (not subject to the reporting requirements of Sections 13 or 15(d) of the Exchange Act), there are additional information requirements. The issuer must provide the seller and prospective purchaser, upon request, with reasonably current information about the issuer’s management team, financials, etc.

This new exemption, which is found in Section 4(a)(7) of the Securities Act, should provide a useful alternative to the Rule 144 safe harbor, which requires that the securities have been outstanding for at least 6 months if the issuer is a reporting company, or 1 year in all other cases. Rule 144 also places limits on the amount of stock that can be sold, a limitation that is not present in the Section 4(a)(7) exemption.

The new exemption also will provide a simplified alternative to the “Section 4(a)(1 ½) exemption,” which has been developed over a period of several years, but which has never been officially codified into law.

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83(b) Basics for Startup Founders and Employees

Typically, any blog post or article about a section of the tax code promises to be a snoozer, but knowing about Section 83(b) is crucial to any startup founders and employees. It’s pretty easy to do it right, but if you are sloppy or uninformed, and you mess it up, and you are in a world of pain. This could be the most important blog post any startup founder or employee reads.

Why is Section 83(b) so important? Typically under Section 83 of the tax code, a founder or employee does not recognize income on stock until the stock vests. When I refer to income, I mean the difference between the fair market value of the stock and the price paid for the stock. Section 83(b), however, allows the founder or employee to make a voluntary election to recognize income upon purchase of the stock, rather than waiting until the stock vests. If the founder/employee does not make the 83(b) election, she may have a great deal of income by the time the stock vests, particularly if the stock value increases substantially over time. OK, I know your eyes are glazing over, but indulge me a bit longer.

Let’s look at two different scenarios — failing to make the 83(b) election, and making the 83(b) election. Suppose we have two co-founders, Reggie and Daniella. Each gets 1 million shares of stock when they form their corporation, at a price of $0.001/share. The stock is subject to four year vesting with a one year cliff (see my other blog post on the importance of vesting). Reggie does not make an 83(b) election. By the end of the first year, 25% of Reggie’s stock is vested, and because of the efforts of the founders and the interest shown in the company by investors and the public, the stock is now worth $1/share. Reggie recognizes income on the vested stock equal to the difference between $1/share and $0.001/share, or $0.999/share. Multiply that by the number of his vested shares, and you’ll see that Reggie has recognized income of $249,750 on his vested shares. As time goes on and more of Reggie’s stock vests, he will continue to recognize income equal to the difference between the FMV of that vesting stock and the original price of $0.001/share. In addition, the company has to pay the employer share of FICA tax on the income, and withhold federal, state and local income taxes. Both Reggie and the company are taking a big tax hit because he failed to make that 83(b) election.

Now let’s look at Daniella. She got the same amount of stock, at the same price, and is subject to the same vesting schedule, but she made the 83(b) election. Instead of recognizing income of $249,750 at the end of Year 1 when 25% of her stock vests, she chose to recognize income at the beginning of Year 1, when she first received the stock and when its fair market value was pretty much equal to the price of $0.001. So basically, Daniella recognizes no income, because at the outset the stock had no real value.

Hopefully these two examples will make clear why the 83(b) election is a crucial issue for founders and employees. To make a timely 83(b) election, the purchaser must file the election with the IRS prior to the date of purchase, or within 30 days after purchasing the stock. No exceptions. In counting those 30 days, the IRS includes Saturdays, Sundays, and holidays. Best practice is to sign the 83(b) election form immediately upon purchasing the stock, and mail it by certified mail, return receipt requested, to the IRS that same day. Give a copy of the signed 83(b) election to the company for its records, and attach a copy to the purchaser’s federal tax return for the year in which the stock was purchased.