Taxing Founders’ Stock
52 Pages Posted: 4 Dec 2010 Last revised: 31 Oct 2011
Date Written: February 13, 2011
Founders of a start-up usually take common stock as a large portion of their compensation for current and future labor efforts. By electing to pay a nominal amount of ordinary income tax on the speculative value of the stock when it is received, founders pay tax on any appreciation at the long-term capital gains rate. In a recent Harvard Law Review article, Professors Ron Gilson and David Schizer argued that this practice of paying founders with tax-favored “cheap stock” is an efficient subsidy for entrepreneurship. I disagree.
This Article argues that the preferential tax treatment of founders’ stock cannot be normatively justified. The economic efficiency case for a tax preference for founders’ stock is weak: tax is a clumsy policy instrument, and tax has a limited effect on entrepreneurial entry. Geographic, cultural, and business factors are far more important, as are non-tax legal factors like immigration policy, employment law, bankruptcy, and securities law.
The case for reform is compelling. Taxing founders at a low rate is a conspicuous loophole in the fabric of our progressive income tax system, uniquely un-dermining our shared commitment to equal opportunity and distributive jus-tice. Founders’ stock is often bequeathed to heirs who receive a step up in basis, leaving a legacy of dynastic wealth that is exempt from the income tax and subject only to the rather dodgy application of the estate tax.
While it would be normatively desirable to tax gains from founders’ stock at the same rate as labor income, fixing the problem is not administratively feasible within our current tax system. I offer solutions that policymakers might consider as part of a broader tax reform and deficit reduction effort.
Keywords: tax, entrepreneurship, capital gains, innovation
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