On October 22, 2015, Twitter, Inc., and its CEO, Jack Dorsey, entered into a Contribution Agreement pursuant to which Dorsey contributed to Twitter for no consideration 6,814,085 shares of Twitter’s common stock contingent upon Twitter’s shareholders approving an equity incentive plan that allows for a number of shares equal to the contribution to be granted over time to Twitter’s employees. Twitter agreed to indemnify Dorsey from any taxes he incurred in the transaction. This move created headlines and caused some to ask questions like “How is that taxed, exactly?”
The use of corporate stock held by shareholders for compensating employees of the corporation is actually a reasonably well understood path, though not without some twists. As a variation on a theme, Dorsey’s arrangement has some consequences that seem uncertain, which highlight the value of the indemnity to Dorsey. Below are our thoughts based solely on what we can learn from publicly filed documents. There may be facts out there not in the public that could change the analysis, perhaps even materially.
Stock for Services: Employer and Employee Outcomes
In general, when an employee receives stock of his or her employer, the value of that stock is included in the employee’s income when the stock becomes substantially vested. For purposes of this discussion, we’ll skip the effects of making an election under section 83(b) of the Internal Revenue Code (the “Code”) to accelerate vesting (but, for those interested, a quick primer on section 83(b) elections is available here). As long as the employer properly reports the income from substantially vested stock on the employee’s Form W-2, the employer generally gets an income tax deduction in an equal amount.
If the corporation sells the stock to the employee (for example on the exercise of a stock option), the income recognized by the employee is the excess, if any, of the value of the stock on the sale date over the selling price for the stock. The corporation’s deduction is the same amount.
When a shareholder makes a direct transfer to an employee of the corporation in connection with the performance of services, under Treasury Regulation section 1.83-6(d), the corporation gets a deduction as if it engaged in the transaction directly. The employee recognizes the same amount of income and the corporation gets the same deduction.
Shareholder Delivery of Stock for Services: Shareholder Consequences
While the tax effects to the employee and the corporation remain unchanged when a shareholder delivers the corporation’s stock, the outcome to the shareholder can get complicated. The rules appear to have been written for the situation where the employee works for a wholly-owned subsidiary of a parent corporation. When the shareholder is an individual who owns less than all of the stock, unexpected results can occur.
When a shareholder gives stock to an employee, it’s treated as if the shares were contributed to the capital of the corporation. If the employee pays the shareholder for those shares, the form of that transaction is not followed. Rather, the IRS treats the shareholder as if it sold the stock to the corporation and the corporation then sold the stock to the employee. Why does this matter?
If the form of the sale were respected, the shareholder would generally recognize gain or loss equal to the difference between the selling price for the shares and the shareholder’s tax basis in those shares.
In a sale of shares of a corporation back to the corporation (i.e., a redemption), the seller’s tax consequences (as determined under Section 301 and 302 of the Internal Revenue Code) might be taxed as if it were a sale. However, depending on the circumstances, that redemption might also be taxed as a dividend, as a tax-free recovery of the shareholder’s tax basis in the shares, or as gain from the sale of stock. As a result, depending on the circumstances, the redemption fiction could result in the shareholder recognizing (i) the same tax as a sale (if the shares have $0 tax basis and capital gains and dividend income are taxed at the same rate), (ii) more tax than a sale (if E&P equals or exceeds the gain), or (iii) less tax than a sale (if the corporation operates at a loss and thus has no E&P, the redemption could allow disproportionate or complete recovery of tax basis).
How is the shareholder taxed if there’s no consideration paid to the shareholder for the shares deemed contributed to the corporation? First, if the shareholder has a built-in loss with respect to the contributed shares, the Supreme Court held (in Commissioner v. Fink, 483 U.S. 89 (1987)), that the contribution was not the appropriate time to recognize that loss. Instead, the shareholder’s basis in the shares surrendered is re-spread among the shares retained by the shareholder. What happens if the shareholder has gain in its shares?
If the shareholder has gain in the contributed shares, we start with the premise under section 1001 of the Code that all sales or exchanges are taxable unless an applicable exception permits non-recognition of gain. If the shareholder owns 80% of the voting power and 80% of each non-voting class of stock, then the contribution could be tax free under section 351 of the Code.
Absent that factual circumstance, theories of non-recognition get more sketchy. The IRS has long held (in Rev. Rul. 80-196) that transfers from shareholders to employees are not gifts. Perhaps this contribution to capital is not a “sale or exchange”? If there was no exchange then what happened to the shareholder’s basis in the shares surrendered? In at least one private letter ruling (PLR 8213103 (Dec. 31, 1981)), the IRS held that such a contribution to capital was tax-free to the contributing shareholder, but relied on the provision of the Code that says a contribution to capital is not income to the recipient-corporation. A taxpayer should rely on that theory with a great deal of caution. Perhaps the converse of Fink provides for non-recognition? Who’s to say? In at least one private letter ruling (PLR 200118046 (May 7, 2001)) where the IRS could have reached an answer, they appear to have avoided answering this question.
At this point, it seems Dorsey was well advised to receive indemnification for any taxes he might incur as a result of this transaction.
Should the other shareholders of Twitter recognize income? After all, they seem to have had an increase in the value of their shares because the number of shares outstanding has decreased, at least until the shares are re-granted to employees. Neither Congress nor the IRS seem to have taken that position yet for one-off transactions like this with a widely-held public corporation.