Founder Shares Issued After a SAFE: Is It Taxable?

Is it taxable to issue founder stock after a SAFE?

It can be. When a company transfers stock to someone in connection with their work, the stock's fair market value minus the amount paid is taxed as pay (26 U.S.C. 83(a)). The rule covers past, present and future work (26 CFR 1.83-3(f)). If founders buy common stock at a tiny price after investors have put SAFE money in, the stock may be worth more than the price, and the gap is ordinary income.

What makes a case not simple:

• The value is a facts question. No IRS regulation or published ruling sets how an outstanding SAFE affects common stock value.
• Vesting. Without an 83(b) election, vesting shares are taxed as they vest, at their value then, which can be far higher after a priced round.
• The company has payroll duties. A founder who works as an officer is usually an employee, so the gap is wages (Publication 15).
• Shares already issued in an earlier year. Returns and payroll filings may need correcting.

Gather: each SAFE's date, amount and valuation cap; the board consents that issued the founder shares; the number of shares, the price and the date paid; the vesting terms; any 83(b) filed; and anything founders contributed besides cash, such as code.

Why can SAFE money make founder common stock worth more than its price?

A SAFE puts investor cash in the company before founders hold their shares. Fair market value is what the stock would sell for, and a company holding new cash with an investor-backed cap may be worth more than a few hundred dollars split across millions of shares. The common stock still ranks below the SAFE holders' rights, so its value per share need not equal the price the SAFE cap implies. Where it lands is a judgment on the facts, and this page does not value stock or cover a 409A valuation.

Two facts can push the value up: a large SAFE, and a short gap between the founder shares and a priced round at a known price. How the SAFE itself is taxed to the company is covered in SAFEs and convertible notes.

How much is taxed as pay, and in which year?

The amount is value minus price paid; the year depends on vesting and on any 83(b) election (26 CFR 1.83-1; Publication 525).

Pay from stock is ordinary income, the same as salary. Your basis in the shares is the price paid plus the amount taxed as pay (Publication 525). Reporting it on your return is covered in founder stock on your tax return.

Does an 83(b) election make the tax go away?

No. An 83(b) election taxes the gap at the issue date instead of at each vesting date (26 U.S.C. 83(b)). If SAFE money already lifted the value, the election makes that gap taxable now. What it removes is tax on later growth as pay, so for vesting shares it usually still matters.

The election is due within 30 days of the transfer and cannot be revoked without IRS consent (26 U.S.C. 83(b)(2)). A founder who paid full value can still file one (26 CFR 1.83-2(a)). How to file and what happens after a missed deadline are in founder shares that vest.

What does the company have to report and withhold on founder stock?

For an employee founder, the gap is wages: the company reports it on Form W-2 and owes withholding on it. Pay in a form other than cash is subject to income tax withholding and Social Security, Medicare and federal unemployment taxes at its value (Publication 15).

Stock pays no cash to withhold from, so the founder must fund the withholding or the company takes it from later cash pay; income tax must be recovered by the end of the same calendar year. Either way, the company owes the tax it failed to withhold (Publication 15); once the founder pays the income tax, it is not collected again from the company, but penalties still apply (26 U.S.C. 3402(d)). A founder who is not an employee gets the amount on an information return instead.

The company may deduct the same amount in the year the founder includes it. It is treated as included if the company timely files the W-2 or other information return (26 CFR 1.83-6(a)). No deduction is allowed where the stock is a capital cost, such as stock issued to a promoter for organizing the company. How much to pay founders in cash is covered in founder salary in a venture-backed corporation.

Does contributing code or IP for the founder shares change the answer?

It can. Stock received for property, such as code or other IP the founders own, is not pay, and if section 351 applies the exchange itself is not taxed: no gain or loss is recognized when people transfer property for stock and, right after, they are in control of the company (26 U.S.C. 351). Control means at least 80% of the total voting power and of the total shares of every other class of stock (26 U.S.C. 368(c)).

Three limits:

• Stock for services is not stock for property. If the shares are worth more than the code plus cash contributed, the extra is still pay (26 CFR 1.351-1(a)).
• The control test. SAFE holders own no stock until the SAFE converts. Whether a SAFE counts as stock for tax is unsettled. Stock rights and warrants are not stock for this test (26 CFR 1.351-1(a)(1)); if a SAFE were stock, it could be a class the founders do not own, which puts control at risk. If section 351 fails, the exchange is taxable, and gain on code a founder wrote is ordinary income, not capital gain (26 U.S.C. 1221(a)(3)).
• The code must be property the founders own and transfer. A promise of future work is services, not property.

A founder who owns at least 1% of the company's stock right after the exchange attaches a section 351 statement to that year's return, and the company attaches one to its own return (26 CFR 1.351-3); see founder stock on your tax return.

How do we fix founder stock issued after a SAFE before the priced round?

Pick a fix the sources support, document it, and act before the round, because investors' diligence will look at the founder stock issue (tax clean-up before investor due diligence).

Steps in order:

1. Gather the SAFE terms, board consents, share counts, prices and dates.
2. Settle the common stock's value at the issue date, on the facts.
3. Choose a fix and record it in board consents that state the price and what was contributed.
4. For vesting shares, file an 83(b) within 30 days of the transfer.
5. Run the pay through payroll, or file the information return, for the year of the transfer.

Whether these shares qualify for QSBS, and when the clock starts, is covered in QSBS for founders and early employees.

We issued founder shares last year and reported nothing: what now?

Correct both sides. For an employee founder, the company files Form W-2c and W-3c for the missed wages and Form 941-X for the Social Security and Medicare tax (Publication 15). Income tax withholding for a prior year generally cannot be adjusted except for an administrative error, so the founder amends their return (Form 1040-X) and pays the income tax, with interest.

Late payroll tax can bring deposit penalties of 2% to 15% plus interest, and if the company cannot pay, founders responsible for its payroll who willfully failed to withhold or pay can be personally liable for 100% of it, as the trust fund recovery penalty (Publication 15). If the shares vest and no 83(b) was filed within 30 days, the shares are taxed as they vest instead; see founder shares that vest. Missed years and a round in progress make this a case for professional judgment.

Example

All figures are illustrative and in US dollars.

A $1 million SAFE, then founder shares

A seed fund buys a $1,000,000 SAFE at a $10,000,000 cap. A month later, two founders each buy 4,000,000 shares of fully vested common at $0.0001, paying $400 each. If the common is worth $0.05 a share, each founder's shares are worth $200,000, and each has $199,600 of pay that year. If the founders are employees, the company reports it on their W-2s and owes withholding on it.

Shares issued last year, nothing reported

The same founder is an employee and the shares were issued last year. The $199,600 belonged on last year's W-2. The company files a W-2c and W-3c and a 941-X for Social Security and Medicare, and the founder files a 1040-X and pays the income tax and interest.

Code for shares

The founders transfer code they wrote and still own, plus $1,000, for all the common. If they control the company right after, and the code is worth what the stock is worth beyond the cash, section 351 can shelter the exchange. If the stock is worth more, the excess is pay. If section 351 fails, the founders are taxed on the gain on the code as ordinary income. Whether the SAFE affects control is the question to settle before the round.

Different for you?

• The shares vest, or the 30 days for the 83(b) have passed: see founder shares that vest.
• You filed the 83(b) and need to report it: see founder stock on your tax return, or get individual tax help.
• The company's payroll, W-2s or Form 1120 need correcting: see tax clean-up before investor due diligence and get corporate tax help.
• The company is an LLC or another state's corporation: see moving a startup into a Delaware corporation.
• You want to know how the SAFE is taxed to the company: see SAFEs and convertible notes.
• You live and work outside the US: see founder shares that vest; in Canada, see Canadian co-founder with vesting US startup shares.
• QSBS matters for your exit: see QSBS for founders and early employees.