Resolving Tax Basis Concerns With Multiple Levels Of Investors For Tech M&A

Tech companies rely greatly on investors to fund their companies’ activities. Generally, there are three levels of investors in a company, the 1) Founders, 2) Employees, and 3) outside investors. When engaged in an M&A transaction an investor will pay taxes on the sale according to their basis in the company stock. The proposed transaction may require shareholder’s approval to complete the transaction. To maximize returns and prevent shareholder disapproval, their individual basis should be established at the onset of investment.

It is common that founders and key employees to own restricted stock in the tech company in exchange for stock. Restricted stock is equity stock which interest does not fully vest until certain conditions are met. When the shareholder’s interest vest, the value of the stock is taxed as ordinary income. When an M&A transaction is complete, the stock will be taxed at capital gains rate. Their basis will be valued at the FMV of the time their interest vest.

Under Sections 83 of the Internal Revenue Code, Section 83(b) election allows founders and employees to determine whether to have their basis be valued at the time of issue or the time interest vest. The election must be made within 30 days of the initial issue of stock.[1] By the use of section 83(b) election, a founder or employee shareholder, whose approval is necessary for an M&A taxation, may determine a tax basis at the date of issue which will provide him or her with the most significant tax benefit at the time of sale.

The IRS gives the following example for guidance.

“Company A is a privately held corporation and no stock in Company A is traded on an established securities market. On April 1, 2012, in connection with the performance of services, Company A transfers to E, its employee, 25,000 shares of substantially non-vested stock in Company A. In exchange for the stock, E pays Company A $25,000, representing the fair market value of the shares at the time of the transfer. The restricted stock agreement provides that if E ceases to provide services to Company A as an employee prior to April 1, 2014, Company A will repurchase the stock from E for the lesser of the then current fair market value or the original purchase price of $25,000. E’s ownership of the 25,000 shares of stock will not be treated as substantially vested until April 1, 2014, and will only be treated as substantially vested if E continues to provide services to Company A as an employee until April 1, 2014. On April 1, 2012, E makes a valid election under § 83(b) with respect to the 25,000 shares of Company A stock. Because the excess of the fair market value of the property ($25,000) over the amount E paid for the property ($25,000) is $0, E includes $0 in gross income for 2012 as a result of the stock transfer and related § 83(b) election. The 25,000 shares of stock become substantially vested on April 1, 2014, when the fair market value of the shares is $40,000. No compensation is includible in E’s gross income when the shares become substantially vested on April 1, 2014. In 2015, E sells the stock for $60,000. As a result of the sale, E realizes $35,000 ($60,000 sale price – $25,000 basis) of gain, which is a capital gain.”[2]


[1] https://www.law.cornell.edu/uscode/text/26/83

[2] Rev. Proc 2012-29, https://www.irs.gov/pub/irs-drop/rp-12-29.pdf