Examining the Tax Advantage of Founders' Stock

Abstract

Recent commentary has described founders' stock as tax-advantaged because it converts founders' compensation income into capital gains. In this paper we describe various founders' stock strategies that offer this character conversion and then analyze whether they are, on the whole, tax advantageous. While the founders' stock strategies favorably convert the character of the founders' income, they simultaneously turn the company's compensation deductions into non-deductions. Whether founders' stock is tax-advantaged overall depends on whether the benefit of the founders' character conversion outweighs the cost of the company's lost deductions. We use various hypothetical to illustrate this tradeoff. We conclude that founders' stock is likely to be significantly tax-advantaged only in those cases where the start up company shows great promise early on but ultimately never develops into a profitable enterprise.

Even in that subset of cases where founders' stock turns out to be tax-advantaged, the advantage exists only because of the tax law's overly harsh treatment of net operating losses. Therefore, whatever tax advantage that exists for founders' stock is best viewed as a partial move towards the optimal treatment of tax losses, not as a stand-alone tax benefit that needs to be eliminated.

Keywords: founders' stock, stock options, joint tax perspective, net operating losses, equity compensation, venture capital, startup companies