What are the tax consequences when purchasing shares with a promissory note?

QUESTION:

I’m being offered founders shares in a startup that has seed funding. As part of the deal, these shares are being purchased with a promissory note.

What are the tax consequences for a promissory note with a nonrecourse obligation collateralized only by the purchased shares? Am I going to incur any taxes as a result of acquiring Founders shares in this manner? Also, does this affect the 83b election in any way?

Thanks!

ANSWER:

Charles Swan

Charles Swan

by Charles Swan at www.thevirtualcfo.net

There are no tax consequnces relating to the non-recourse note. This structure is generally offered to key employees as an alternative to Incentive Stock Options (ISOs).

The designed scenario is that the stock is sold at current fair market value (FMV), subject to a non-recourse note, with repurchase options by the company that expire over time – a reverse vesting. If a valid Section 83b election is made, then the tax on the stock purchase is elected to occur at the time of purchase, and since the stock was purchased at FMV, the tax is zero. The important feature is that the clock for capital gains purposes starts ticking at the time of purchase, so that if everything goes according to the business plan that you presented to investors, you should be able to sell your shares and get long-term capital gains treatment.

If however, a valid 83b election is not make, then there is tax at ordinary income rates on the difference between the purchase price (FMV at time 0), and the current FMV. The capital gains holding period would then start.

Alternatively, stock options granted under an ISO would not be taxed until sale, but there is then a holding period for capital gains purposes. There are $ limitations on ISO stock, which is why the stock purchase is sometimes used for founders.

Comments & Advice:
  1. Ethan Stone Ethan Stone says:

    This is not completely accurate. Under the applicable regulations, the IRS has indicated that it may treat stock purchased with non-recourse debt as an option, in which case you cannot make an 83(b) election until you have paid off the debt (or converted it to recourse). This is not a bright line rule, so many practitioners believe that some amount of non-recourse debt is probably OK, so long as the employee has something significant at stake. I have seen advice in this regard vary from 25% to 51% minimum (but other people feel that using any non-recourse debt at all is taking a big risk with your 83(b) election). You can use recourse debt for the portion at risk, but cash is safer.

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