a summary of various tax issues that startup companies face

1. Presented by: Roger Royse
Taxing Startups
Traps, Pitfalls and Opportunities

2. • Roger Royse is the founder of the Royse Law Firm. He is a
frequent speaker and is active in several leadership roles in the
American Bar Association.
• Chair of the Tax Practice Management Committee for the ABA
Tax Law Section.
• Fellow of the American College of Tax Counsel.
• Member of the Executive Committee, Taxation Section of the
California Lawyers Association.
• Author of “Dead On Arrival, How to Avoid the Legal Mistakes
That Could Kill Your Startup.”
• Adjunct professor for the Master of Laws (LL.M.) in Taxation
Program at Golden Gate University and an Instructor at
Stanford Continuing Studies.
Roger Royse
2

3. Tax Issues for Startup Companies
1. Choice of Entity
2. Qualified Small Business Stock
3. Section 305 Issues
4. Startup Formation Issues
5. Taking Money Off the Table
6. Taxation of Stock Rights
7. Treatment of Partial Recourse Debt
8. Taxation of Compensatory Partnership Interests
9. Incorporation of an LLC
10. § 409A Deferred Compensation
11. Employee vs. Independent Contractor Issues
12. R&D Credits for Payroll Taxes
13. Section 871(m) and Foreign Investors
14. Section 83(i) Qualified Equity Grants
3

4. Choice of Entity
4

5. Choice of Entity Assuming Domestic Entity
5
LLC (not taxed as corp) S Corporation C Corporation
Entity Level
Federal Income
Taxes
No federal tax at LLC level. Generally no tax at S
corporation level; some excise
taxes and built in gains taxes
may apply.
Income tax on earnings at
corporate level.
Eligibility
Requirements of
Owners and
Equity
No restrictions. US citizens or resident
individuals, certain trusts, and
certain tax-exempt entities.
100 max (generally).
One class of stock limitation.
No restrictions.
Entity Level
California Taxes
Gross receipts fee, unlike state
law partnerships. $800
minimum.
Minimum franchise tax of $800
or 1.5% taxable income.
8.84% corporate rate
applies or $800 minimum
franchise tax.
Option Plans,
NSOs, ISOs
Employees & consultants can be
given options to acquire LLC
interests, but such options are
generally more complex and
cause §704(b) challenges. ISOs
not available, but profits interests
generally superior to ISO.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.

6. Choice of Entity Assuming Domestic Entity (cont.)
6
LLC (not taxed as corp) S Corporation C Corporation
Employment
Taxes
Distributive share may be self
employment income.
Reasonable compensation
subject to FICA/FUTA.
Distributions are not (also not
NII).
Reasonable compensation
subject to FICA/FUTA.
Distributions are not (but attract
3.8% NIIT).
Treatment of
Foreign Owners
Foreign members subject to US tax on
their share of effectively connected
income and FDAP of LLC; branch
profits tax may apply.
Foreigners cannot be
shareholders of S corporation
(except for ESBTs with NRA
beneficiaries).
Foreigners are subject to
withholding tax on dividends
from US corporation, subject to
treaty rate or exemption.
Foreign Individual
Owners - Transfer
Taxes
Unclear. N/A. Foreigners cannot be
shareholders of S corporation.
Corporate stock may be gifted
tax free. U.S. corporate stock
will be part of taxable estate,
however.
Conversion to
Another Entity
May generally be incorporated tax free,
but see discussion herein.
Conversion between partnership and
DRE can cause tax (e.g., investment
company rules).
Can convert tax-free to C
corporation by revoking election;
converting to LLC is a taxable
liquidation.
Can convert to S corporation by
making election (built in gains
tax may apply to later
dispositions of appreciated
property). Conversion to LLC a
taxable liquidation.
Taxes on Sale or
Liquidation
One level of tax, generally capital gain
except for amount allocable to certain
assets.
“Flowthrough” of international tax
characteristics to foreign seller
(including ECI).
One level of tax on sale of stock
or assets, generally capital gain
on stock sale.
No 754 election, decreasing
desirability of stock sale to
buyer.
Potential double tax. Corporate
tax on sale of assets.
Shareholder level tax on sale of
stock or liquidation.
Sales by foreign shareholder
generally not U.S. taxed.

7. Qualified Small Business Stock
7

8. Qualified Small Business Stock – 1202 and 1045
General Requirements
Original issue
Five-year holding period
100% post-Sept. 27, 2010
50% 8/11/1993-2/17/2009
75% 2/18/2009–9/27/2010
Domestic C Corporation issuer
Up to $10 million or 10 times basis exclusion
1045 Rollover treatment
 $50 million Gross Assets Test
 Active Business Test (80%)
 No significant redemptions
 Non-corporate holders
 California does not conform
Note: California does not follow federal income tax treatment of QSB stock under I.R.C. § 1202.
8

9. QSBS Pitfalls
• S corporations
• LLC conversions
• Convertibles and holding period
• Timing to meet the gross assets test
• Taking money off the table through investment/redemption transactions
• Significant redemptions
• Lack of documentation
9

10. QSBS Planning with LLCs
• LLC to C Corp conversion
• Post conversion gain can be QSBS gain
• Basis for QSBS exclusion is value at conversion
• Built in gain at conversion is not QSBS gain
• If FMV at conversion > $1 million, can increase QSBS exclusion with 10X basis exclusion
10

11. QSBS Planning with S Corporations
• Stock issue by S corporation is not QSBS
• S corporation drops assets down to new C corporation in exchange for stock
• S corporation can hold QSBS in new C corp
11

12. QSBS Rollover
• Rollovers under IRC § 1045
• Non-corporate taxpayer
• QSBS stock has been held > 6 months
• Replacement QSBS purchased within 60 days
• 1045 election
• Can defer gain if 5-year holding period not met
• Partnership sales – each partner can rollover
12

13. QSBS Planning - Trusts
• Transfers by gift preserve exclusion
• Multiple exclusions through gifting to trusts
• Intentionally defective grantor trusts
• Irrevocable Non-Grantor Trusts
13

14. Section 305
1

15. § 305 Traps
• General rules: Dividends are taxable to the extent of E&P (§§ 301, 316) and redemptions
are taxed as sales or exchanges. § 302
• Exceptions to general rule: Stock dividends are not taxable (§ 305(a)) and some
redemptions are taxed as § 301 distributions.
• Exception to exception: “Disproportionate” stock dividends are taxable. § 305(b).
15

16. Section 305(c) Dividends
• § 305(c): IRS may deem dividends to exist when proportionate interests altered.
• Rev. Rul. 78-60
• Periodic small redemptions by shareholders of a closely held corporation. Small changes in ownership resulting from
these distributions.
• Issue 1: Redeeming shareholders not eligible for § 302(a) exchange treatment. No § 302(b) exceptions
apply. Therefore, § 301 distributions.
• Issue 2: Remaining shareholders had small percentage increases. See § 305(c) Regs. re: § 301 dividend
treatment for these shareholders.
• Treatment to Recipient Shareholder — Other Effects
• Dividend distribution amount is FMV of stock & then an E&P reduction.
• Allocation of tax basis in proportion to the relative fair market values of various shares on the date of the
distribution. § 307(a).
• Tacking of the holding period. § 1223(5).
• § 305 impacts a stock rights distribution.
• § 307(b) – no allocation of tax basis when rights are distributed & rights value less than 15%.
16

17. § 305 Conversion Rate Adjustments
• Application to convertible instruments: E.g., preferred, warrants, convertible debts have a
conversion rate determining the amount of stock they convert into.
• Under §305(c), holders of convertible instruments may be deemed to receive a stock distribution
if:
• There is a conversion rate adjustment (a “CRA”) that increases holders’ proportionate interest in the earnings and
profits or assets of the issuer, and
• The deemed distribution may be characterized as a taxable stock distribution if it was a “disproportionate distribution”
under § 305(b)(2), (3), (4), or (5).
• CRAs occur to protect value of convertible instrument (e.g., anti-dilution, repayment for
distributions from corporation to existing shareholders).
• CRA §305(c) Exception: “[A]n applicable adjustment made pursuant to a bona fide, reasonable
adjustment formula that has the effect of preventing dilution of a shareholder’s interest is not a
deemed distribution of stock to which Sections 305(b) and 301 apply.” Treas. Reg. § 1.305-
7(b)(1).
• Note: CRAs reflecting adjustments taxable distributions do not get this exception.
17

18. § 305 CRA - Common Startup Scenario
• Stock Dividends
Taxed to the extent of E&P:
• § 305(b)(4): distributions ‘on’ preferred stock.
• § 305(b)(5): distributions ‘of’ convertible preferred stock
• § 305(b)(2): cash to some, increase in proportionate interest to others
• Convertible Preferred Stock
Can be treated as deemed dividend under disproportionate distribution rule.
• If conversion ratio of class of stock changes over time, this can cause disproportionate distribution because it can cause
classes to disproportionately increase interests in assets or E&P of corp.
Treas. Reg. § 1.305-3(e), Ex. 6: Corp, Class A and B stock only
• Class A has yearly cash dividends
• Class B converts into Class A at different rates over
time (see table to right)
• Result: Class B gets .05 shares of Class A
deemed dividend per year
Year Conversion Ratio
0 1 Class B : 1 Class A
1 1 Class B : 1.05 Class A
2 1 Class B : 1.10 Class A
N 1 Class B : (1 + .05*N) Class A
18

19. § 305(c) Proposed Regulations
Change/
clarification
Current rules Proposed rules
Amount of deemed
distribution
The value of the
additional shares to
which the
convertible
instrument holder
now entitled
The increased value of the conversion privilege
(compared to what instrument would have been worth
if no adjustment) without regards to potential future
adjustments.
Timing of deemed
distribution
Unclear Earlier of date of adjustment or date of distribution
giving rise to deemed distribution.
Withholding rules Unclear Must withhold. New rules must be followed by issuer
which, if followed, cause withholding agent to need to
withhold (with special timing rules for when
withholding is due by).
Cash to withhold comes from other distributions on
instrument; sale of instrument; use of assets/income
held for beneficial owner; direct from beneficial owner.
19

20. Startup Formation Issues
2

21. Startup Formation Issues
• Issue 1: For § 351 nonrecognition, stock must be for “property” not “services”
• Intangible property or services?
• Also, be careful of cross-border § 351s
• Transfer of intangibles
• Final regulations issued under § 367
• Transfers of foreign goodwill and going concern value are taxable
• Issue 2: § 351 plan of contribution and late founders contributing property
• Issue: Cannot get 80% control group over OldCo
• Possible Solution: Incorporate and merge, check and merge
• Step transaction and 351 control requirement issues. Rev. Ruling 70-140, Weikel v CIR, 51 TCM 432 (1986)
SH
Corp.
Stock
Property
(?)
Late
SH
NewCo
Property
Stock
TIME
NewCo
OldCo
21

22. Startup Formation Issues (cont.)
• Issue 3: Corporate capital shifting
• Taxation: Unlike partnerships, not taxable unless § 305 triggered
• A common event you might not notice: Frequently occurs; e.g., preferred stock with liquidation preference higher than
contribution
• Valuation: Preferred stock may drive the liquidation value of common stock value to $0. But: liquidation value =/= fair
market value!
• Issue 4: SAFEs and convertible note alternatives
• Note alternatives: Agreements that convert (perhaps for additional compensation) into equity of company on close of
financing transaction. No interest or maturity date.
• KISS (Keep It Simple Security)
• SAFE (Simple Agreement for Future Equity)
• Tokens
• Interest deduction limitations
• 2nd class of stock can terminate S election
• Classified as equity, debt or prepaid forward contracts?
• Tacking of holding periods
22

23. Startup Formation Issues (cont.)
• Issue 5: Vesting vs. stock grant for founders
• Fixed split versus dynamic split (discussed in following slides)
• Issue 6: Series FF stock to get founders liquidity without compensation
• Basics: Founders want the right to sell their shares in financing rounds
• Business challenge: Investors want preferred stock, not founders’ common; required redemptions and structuring to get
around
• Tax challenge: Risk of disguised compensation if structuring implied an overly high value to Founders’ common stock
• Solution: Founder’s series FF common that is convertible to preferred
• Issue 7: Convertible debt for S corporations
• Be careful not to trigger second class of stock rule!
• Cannot be equity under general rules, and cannot be call option treated as second class of debt
• Convertible debt terminates an S election if it fails the “call options test,” which would occur if the conversion exercise price
is less than 90% of its fair market value or is substantially certain to be exercised.
23

24. Startup Formation Issues Dynamic Split
• Traditional fixed-split model: Equity given based on anticipated contributions.
• Dynamic-split model: Equity given based on actual contributions.
• Inputs to dynamic-split model: The dynamic model assigns a relative FMV weight to various contributions from
each participant, and contributions put into model:
 Time Spent Working
 Intellectual Property
 Commissions
 Cash
 Facilities
 Equipment and Supplies
• Outputs: Depending on the relative weighted contributions of each team member,
that member is allocated a corresponding percentage of outstanding equity.
– On “split,” members could return old equity, or be given new equity, to ensure each member
gets appropriate percentage of company.
24

25. Dynamic Split Models – Tax Issues and
Planning
• Potential taxation: Stock for services (§ 83), repeated contributions of property (arguably not under § 351)
• Even worse, equity split is on some future date (when the business could have some real value).
• Possible Solutions:
• Vesting concept with 83(b) elections
• Use of profits interests
• Low valuations
25

26. Taking Money Off the Table
2

27. Taking Money Off the Table
• Often the founders will sell some of their common stock to investors or the company will
redeem their shares at the preferred stock price
• A sale of common stock by a service provider to the employer at preferred stock prices will
result in compensation under section 83, taxed at ordinary rates
• If the Company has E&P, may be section 305 dividend
• Does a sale of common to investors at preferred prices avoid the problem?
27

28. Taxation of Stock Rights
2

29. Stock Rights – Classic Investment Types
Tax
Consequence
s
Convertible Debt Warrant
Timing
No tax upon conversion. No tax upon exercise;
Holder may recognize loss if the warrant lapsed
without exercise.
Basis (assuming
no exercise
price)
Holder has the same basis in the stock
as he had in the convertible debt.
The purchase price of the warrant is included in the
adjusted tax basis of the stock purchased by
exercising the warrant.
Holding Period
of Stock
Depends on
manner of
“exercise”
The holding period of the stock will
include the holding period of the debt
instrument exchange. § 1223 (1); Rev.
Rul. 72-265
Holding period of the stock begins on the day that a
warrant is exercised. § 1223(5)
If the convertible by its terms requires
an additional cash payment on
exercise, the investor takes a split
holding period. Rev. Rul. 62-140
If the warrants are exchanged for stock (other than
NQPS) in a recapitalization or other reorganization
under § 368, the holding periods of the warrants
tacks on to the holding period of the stock acquired
(because warrants are treated as “securities” under
§ 354).

30. Stock Rights – SAFE and KISS
Increasingly, alternative equity derivatives such as SAFEs are being used to
invest, but their tax status is often uncertain
Tax
Treatment
Likelihood Consequences
Potential Tax
Treatment as
Equity?
Maybe; IRS views “stock”
expansively
No holding period problem,
possible QSBS treatment
Potential Tax
Treatment as
Warrant?
Maybe; No payment on exercise,
exercise contingent and uncertain
Uncertain whether holding period tacks as a recap.
Does not tack for QSBS.
Potential Tax
Treatment as
Convertible
Debt?
Low; the distinction between
convertible debt and stock rights
under § 1223(5) is generally
respected.
Tacked holding period. § 1223 (1); Rev. Rul. 72-265
OID,
Section 163(j) deduction limitations
Possible CODI under section 108
Prepaid Variable
Variable Forward
Forward Contract?
Contract?
May be best analogy Holding period commences on conversion

31. Stock Rights – Incentive Stock Options (ISOs)
Event Employee Tax Employer Tax
Grant None None
Transfer of ISO Not allowed except on death n/a
Cancellation of ISO Consideration for cancellation is OI Withhold on OI
amount; take
deduction for
compensation
Lapse of ISO No loss None
Exercise
Note: No § 83(b) allowed except
for AMT purposes
None; basis will equal exercise price
EXCEPTION: AMT inclusion on the amount that
would create OI on a disqualifying
disposition
None
Disqualifying disposition of
stock
Note: If this is likely, use an
NSO instead to get § 83(b)
treatment, avoid AMT hassles
OI = ISO FMV at time of exercise minus
exercise price; get basis credit for OI for
computing LTCG
LTCG on remaining gain
Withhold on OI
amount; take
deduction for
compensation
Qualifying disposition of stock LTCG n/a
Modification, extension, renewal Treated as new grant of stock option; re-
test FMV, etc. at time of modification to
option is not NSO
See “Grant” above
280G Payment in nature of compensation, even
though no income from it
See 280G

32. Stock Rights – Other Compensatory Types
Other Compensatory Types
• Employee Stock Purchase Plans (ESPPs) – Uncommon in startups
• Restricted stock – compensation at vesting or on issuance
• Restricted stock units (RSUs) – compensation at vesting
• Stock appreciation rights (SARs) – 409A issues, ordinary income
• Phantom stock - 409A issues, ordinary income
• Section 83(i) Plan – defers income event if elected

33. Treatment of Partial Resource Debt
3

34. Partial Recourse Debt
Frank Lyon
• SCOTUS held that the title owner had the legal right to take tax deductions
• The transaction was a classic sale leaseback
• Subsequently disallowed by 1986 Tax Reform Act
• Partial Recourse Promissory Note
• Less capital to purchase the shares at the outset
• Commercially reasonable repayment terms
• Adequate stated interest
• Partial Recourse to Maker
• 51% recourse for stock sale
• Section 83(b) election
• Capital gains treatment on restricted stock

35. Taxation of Compensatory Partnership Interests
3

36. Taxation for Compensatory Partnership Interests
• Contingent allocation issues
• If allocations are made before full vesting and exercise, the capital account could be forfeited
and there is no guarantee of liquidation in accordance with capital accounts
• See Rev. Proc 2001-43
• Capital shift
• Capital shift generally occurs when a member with a capital interest agrees to forgo part or all
of its right to proceeds on liquidation of the partnership. A capital shift could also occur when a
restricted interest vests or when a preferred interest is converted into a common interest.
• Taxable event for the member receiving capital.
• Profits interests
• Rev. Proc. 93-27 and Rev. Proc. 2001-43

37. Incorporation of an LLC
3

38. Incorporation of an LLC
Start-ups started as LLCs may want to or need to convert into a corporate form at a later point
because:
• Venture capital investors more comfortable with corporate form
• Potential IPO (but UP-C increasingly popular alternative)
• Availability of Section 368 reorganization on exit
• ISOs
• General increased liquidity
• Qualified Small Business Stock exemption
• Issuance of stock in a C corporation on incorporation of an LLC may qualify as QSB stock
• Stock held in C Corp following termination of S Corp election does not qualify because stock was not issued in a qualifying corporation
Formless Conversion according to state law:
• Section 265 of the Delaware General Corporation Law
• California Corporations Code commencing with sections 200, 1150 and 17710.01.
• Required Documents:
• Cover Sheet
• Articles of Incorporation with Statement of Conversion

39. Incorporation of an LLC (cont.)
Formless conversion according to state law (cont.):
 Much easier process compared to traditional methods
 Generally not taxable, except when liability in excess of basis. IRC § 357(c)
 The entity can generally retain its old EIN. Rev. Rul. 2004-59
For states that do not recognize formless conversion:
The IRS has approved three methods of incorporation. Rev. Rul. 84-111
1. Assets Over
2. Assets Up
3. Interests Over
Can combine assets over and assets up. See Regs. §1.708-1(d)(5) Ex. 7.

40. Incorporation of an LLC (cont.)
• Method 1: Assets Over. Old LLC transfers all its assets and liabilities to the newly formed Newco in
exchange for the stock in the Newco first, and then distributes Newco stock to LLC Members in
liquidation.
• Assume transfer satisfies Section 351.
• Old LLC defers tax by taking a carryover basis and holding period in the stock (adjusted for liabilities
assumed by Newco).
• Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain
recognized by Old LLC).
• LLC Members take a substituted basis in the stock equal to their basis in the membership interests
(adjusted for liabilities assumed by Newco and any gain or loss recognized in the transaction) but will take
a carryover holding period in the stock.

41. Incorporation of an LLC (cont.)
• Method 2: Assets up. Old LLC transfers all its assets and liabilities to LLC Members in liquidation first,
and then LLC Members contribute assets and liabilities of Old LLC to Newco in exchange for Newco
Stock.
• Assume transfer satisfies Section 351.
• LLC Members take a substituted basis in the assets equal to their basis in the membership interests (adjusted
for any gain or loss recognized in the transaction) but will take carryover cost recovery and holding periods in
the assets.
• LLC Members take a carryover basis and holding period in the stock (adjusted for liabilities assumed by
Newco and any gain or loss recognized in the transaction).
• Newco takes substituted basis in the assets equal to the LLC Members’ bases in their membership interests
(adjusted for any gain or loss recognized in the transaction) but will take a carryover holding period and cost
recovery in the assets.

42. Incorporation of an LLC (cont.)
• Method 3: Interests over. LLC Members transfer their Old LLC interests to Newco in exchange for
Newco Stock first, and then Old LLC liquidates, but treated as asset transfer to Newco.
• Assume transfer satisfies Section 351.
• LLC Members take a substituted basis in the Newco Stock equal to their basis in the membership
interests (adjusted for any gain or loss recognized in the transaction and liabilities assumed by
Newco) and will tack the holding periods of their membership interests to the holding period in Newco
Stock.
• Newco takes a carryover basis, holding period, and cost recovery in the assets (adjusted for gain
recognized by LLC Members).

43. Incorporation of an LLC (cont.)
• Debt Issues
• Negative capital accounts:
• Debt in excess of basis.
• There may be a taxable gain where liabilities assumed exceed basis. Rev. Rul. 68-55.
• Partners could consider assuming some of the debt or contributing additional capital.
• Debt Shifting:
• Applicable to “Asset Over” Incorporations
• Transfer of labilities from the LLC to the corporation is a deemed distribution by the LLC to its members, reducing the members’ basis in
their LLC interests.
• May result in taxable gain if there is boot, i.e., total labilities exceed total basis. § 752(b); Treas. Reg. § 1.752-1(e).
• Suspended Losses:
• Sec. 704(d) basis limitation
• At-risk limitation of Sec. 465
• Passive loss limitation of Sec. 469
• Suspended losses triggered on disposition

44. § 409A Deferred Compensation
4

45. § 409A: Basic Analysis
• As a general rule, non-discretionary compensation plans which will be paid in subsequent tax years are subject to
• § 409A.
• Many exceptions apply, which take payments out of § 409A:
• Short-term deferral (certain to be paid within certain time window following final vesting condition)
• Most compensatory equity rights, provided certain requirements met
• Qualified plans
• If subject to § 409A, compensation plans must have the following features, or will be subject to acceleration and
penalty tax rates:
• Payments must be scheduled and generally paid on or within a set time or time window anchored on a
“permissible payment event”, e.g., change-in-control, specified date, death . . .
• Form of payment (lump sum or installments) and time of payment must be specified
• Election to defer compensation must be done by employer or (occasionally) employee timely every year

46. § 409A: Common Tax Issues
 Deferral of founder salary until financing round occurs
 Can always avoid issue by requiring worker be employed at time of financing round to get payment
 Issuance of stock rights to employee prior to beginning services
 Current final regulations: Service provider must provide services to issuer or related entity on date of
grant to be eligible for stock right exceptions
 Proposed regulations: Also OK if service provider reasonably expected to, and does, provide
services to issuer/related entities within 12 months of grant
 “Company is too new to need a §409A valuation for issuing options.”
 No, it probably isn’t. Safe harbor is very helpful.
Views of transaction Tax effect
Vesting occurs at time of financing Short-term deferral, or objective,
nondiscretionary payment under 1.409A-
3(i)(1)
Already vested due to high likelihood of
event
Violation of 409A (financing round not
permissible event)

47. Employee vs. Independent Contractor Issues
4

48. Employee vs. Independent Contractor Issues
• For tax purposes, it is critical that the company correctly determines whether individuals providing
services to the business are employees or independent contractors.
• Business prefer independent contractors to avoid paying Social Security, Medicare taxes, and
unemployment taxes and to avoid providing health insurance coverage.
• Employers run the risk of improperly characterizing independent contractors. IRS is paying more attention
to misclassification issues.
• Companies like Uber and Lyft that treat workers as independent contractors are under scrutiny. If the
employer has significant control over the worker, the IRS may claim the worker should have been classified
as an employee.
• Companies must give their workers IRS Form W-2 setting forth their compensation for the year and
Form 1099 to independent contractors, by February 1st of each year.
• The IRS gives some guidance in IRS Publication 15-A and Form SS-8. The Employment Development
Department provides different factors to determine an employment relationship.

49. Employment Status: The Law
• The presumption is that the worker is an Employee (Cal. Lab. Code § 3357)
• Different agencies/jurisdictions have different tests
• IRS
• DOL/FLSA
• CA Common Law and EDD
• Statutory Employees

50. Employment Status: The Law (cont.)
• IRS: The Control Test
• Behavioral Control
• Financial Control
• Type of Relationship
• DOL/FLSA: Economic Realities Test/Silk Factors
• Focus is on the degree of control the Company has over the worker performing the service. The key inquiry is the
right to control not whether the Company actually exercises the control.
• In July 2015, DOL issued administrative guidance and explained that the test focuses on whether the worker is
economically dependent on the hiring entity or is in business for herself/himself.
• CA Common Law/EDD: S.G. Borello & Sons, Inc. v Dept. of Industrial Relations (1989) 48 Cal.3d
341
• This is a multi-factored test: The most significant factor considered is whether the principal has control or the right to
control the worker as to the work done and the manner and means in which it is performed.
• Statutory Employees

51. Dynamex Decision
• Dynamex Operations West, Inc. v. Superior Court of Los Angeles, 4 Cal.5th 903 (2018) adopts
a three-factor ABC test, which presumes a worker is an employee unless all of the following
tests are satisfied
• Worker is free from control and direction of hiring authority
• Worker performs work outside the usual course of the hiring entity’s business, AND
• Worker is engaged in an independently established trade, occupation of business of the
same nature

52. Dynamex and Tax?
• Decision applies “for purposes of California wage orders” (emphasis in original), not for tax
classifications
• Worker may be classified differently for different purposes
• Will the EDD use Dynamex and become more aggressive?
• EDD has not stated that it will apply Dynamex

53. AB-5
• California Assembly Bill 5 codifies Dynamex in the Labor Code and the Unemployment
Insurance Code “For purposes of the provisions of this code and the Unemployment
Insurance Code, and for the wage orders of the Industrial Welfare Commission…”
• Numerous carve-outs proposed

54. AB-5
• Uber, Lyft and DoorDash threatened to spend $90 million on a 2020 ballot measure unless the
Legislature passes a new bill allowing them to avoid classifying drivers as employees
• California Labor Federation, representing 1,200 unions with 2.1 million members, vowed to
defeat the effort (LA Times, August 30, 2019)

55. R&D Credits for Payroll Taxes
5

56. R&D Credits for Payroll Taxes
The Protecting Americans from Tax Hikes (PATH) Act of 2015
• Small businesses were limited to claim the full R&D credit in the current tax year due to net operating
losses or alternative minimum tax (AMT) positions.
• The PATH Act of 2015 is:
• Making the R&D credit permanent;
• Allowing businesses with less than $50 million in gross receipts to offset the R&D credit against AMT
liability; and
• Allowing certain small businesses with less than $5 million in gross receipts to offset the R&D credit
against payroll taxes.

57. R&D Credits for Payroll Taxes
IRS Notice 2017-23
• The payroll tax credit is not limited to R&D employees but rather can be used to offset the employer’s
share of OASDI taxes for all employees.
• The payroll tax credit can be utilized in the first quarter that begins after the date on which the taxpayer
filed its tax return electing the R&D payroll tax credit.
• For example, if a 2016 tax return is filed on April 15, 2017, the credit can first be used in the quarter beginning on July 1
and ending on Sept. 30, 2017.
• If a qualified small business files its return for a taxable year beginning after Dec. 31, 2015, but fails to
make the payroll tax credit election, it may make the election on an amended return filed on or before
December 31, 2017
• Notice 2017-23 does not provide a de minimis test in regards to gross receipts. As it is written, a
company receiving minimal gross receipts in the form of bank interest or a dividend in any year prior to
the five-year period referenced above would be ineligible to elect the payroll tax credit.

58. Section 871(m) and Foreign Investors
5

59. Dividend Equivalence Tax Exposure and Withholding for
Foreign Investors
• Section 871(m): certain “dividend equivalent” payments that (directly or indirectly) are
contingent upon, or determined by reference to, the payment of a dividend from sources within
the US,” are treated as U.S.-source dividends.
• Section 871(m) ensures that foreign investors cannot hold derivative instruments that replicate
the economic benefits of holding U.S. equity securities taxed at a lower U.S. withholding tax
rate (e.g., portfolio interest).
• Applies if a convertible note has a “delta” of 0.80 or greater, or if a payment on the debt
instrument is determined to be substantially equivalent to a dividend
• “delta” is the rate of change of the derivative instrument’s value with respect to changes in the
value of the underlying security. Thus, a derivative instrument with a delta of 0.8 means that
for every $1.00 the underlying security varies, the derivative instrument varies by $0.80.
• Absent a substantial modification of the instrument, “delta” tested only at issuance.

60. Section 83(i) Qualified Equity Grants
6

61. Section 83(i) Qualified Equity Grants
• Qualified employees may elect to defer income from qualified equity grants for up to five
years.
• Grant must be issued by an eligible corporation to a qualified employee as compensation.
• Must be a written plan under which not less than 80 percent of all United States-based
employees receive grants of stock options or RSUs.
• All qualified employees must have the same rights and privileges to receive qualified stock.
• If a qualified employee makes a section 83(i) election, income taxes are due at the earliest of
when the stock becomes transferable, the employee becomes an excluded employee, the
stock becomes readily tradable on an established securities market, five years after the rights
of the employee in such stock are transferable or are not subject to a substantial risk of
forfeiture, or the employee revokes his or her election.

62. Section 83(i) Qualified Equity Grants
• A qualified employee must make the election with respect to qualified stock no later than 30
days after the first date the rights of the employee in such stock are transferable or are not
subject to a substantial risk of forfeiture, whichever occurs earlier.
• Employers that fail to notify employees can incur significant penalties.
• December 18, 2018 guidance – plan can provide that it is not an 83(i) plan

63. Attendance Verification Code: 8233M
This code is for states that need additional proof of attendance.
It is not a CLE course number.

64. ҉ Symposium 2020 ҉
July 20-24
Hyatt Regency Denver
at Colorado Convention Center
Precursors: Tax, Trust Administration,
and RLT Drafting Intensives

65. For more information, contact us.
Royse Law Firm, PC
www.rroyselaw.com
Silicon Valley
149 Commonwealth Drive
Suite 1001
Menlo Park, CA 94025
P: 650-813-9700
San Francisco
135 Main Street
12th Floor
San Francisco, CA 94105
P: 415-421-9700
Santa Monica
520 Broadway
Suite 200
Santa Monica, CA 90401
P: 424-238-3335
Orange County
135 S. State College Boulevard
Suite 200
Brea, CA 92821
P: 310-481-0125