How to Avoid Costly Mistakes in Founders Stock Issuances

For purposes of this article, I will assume that you have decided to start your own business and structure it as a corporation. This involves filing articles of incorporation with your particular Secretary of State. The articles can be a form you complete online that is provided by the Secretary of State or a document drafted by your attorney.

No matter how you choose to file your articles of incorporation, you will need to specify the number of “authorized” shares in your corporation.  If you don’t know how many to authorize, don’t worry.  This number of shares is largely arbitrary and can be changed at a later date using a board resolution.  The number of authorized shares you specify consists of the total number of shares that your corporation may issue, or in other words, sell or grant, to owners, employees, and other investors.

So, let’s say you decide to authorize 1,000,000 shares.  Here’s where the costly mistake usually comes in.  Most owners will not actually ever issue themselves any of these authorized shares mistakenly believing that the total number of shares they authorized belongs to them.  This is wrong.  In order to own any of the authorized shares, you must first issue those shares, or some fraction of those shares, to yourself and/or fellow owners, employees, and investors.

Why do you need to issue yourself shares? First, you and your newly formed corporation are distinct in the eyes of the law.  The new corporation is viewed as a legal person, albeit not a natural person. So, in order to have some ownership of the corporation, the corporation has to agree to sell or grant some or all of the authorized shares to you. Second, if you are to be the owner of your corporation and not just what is called a “promoter” or “incorporator,” you need to own at least some shares.  In this way you go from being an incorporator to a shareholder. Third, if you ever decide to sell your company a buyer may want to purchase all of your shares to insure that they own all of your rights in the corporation. If you don’t have any properly issued shares, you will have nothing to transfer and therefore, nothing to sell. Lastly, you may want to issue yourself shares very early in your corporation’s growth to minimize the amount of income tax you may have to pay on the difference between what you paid for the shares and the fair market value of the shares. This last point deserves some additional attention.

In many cases, new business owners will grant themselves shares, meaning that the corporation will give the shares for no consideration, or for free, to you, the owner (recall from above that the corporation and you are distinct “people” in the eyes of the law).  So, what the owner (you) paid for those shares is $0.  If this grant of shares does not occur early in the corporation’s development, the shares will increase in value.  This will result in a difference between the fair market value and the consideration paid for the shares at the time of the grant and therefore result in additional tax for the individual receiving those shares.  However, if the shares granted to an owner is done immediately following formation of the corporation, the fair market value of those shares will in all likelihood be very close to the price paid, which is more than $0 but whole heck of alot more than $0. The fair market value of the shares is calculated by multiplying the number of shares granted by the par value of the shares (typically in the range of $0.0001 to $0.01 per share where a large number of shares, say 1,000,000, is involved).  The difference between this calculation and the price paid ($0) is the amount that income tax is due on.  If all this sounds a little confusing, just remember this:  Shares in a corporation are considered income to an individual at the time they are granted.  If you can’t show that you paid something for those shares, you will owe tax on the entire value of the shares.

An owner may avoid this altogether by either granting themselves shares early on or by paying fair market value for the shares, a prospect that is often times unpalatable for small business owners.  In any event, a stitch in time saves nine and in this case, quite a bit of heartburn and perhaps income tax.  As always, consider discussing this subject with your attorney, or accountant, before diving in.  Good luck!