In March 2007 I received stocks of a German startup in exchange for my services.
I know that I need to pay tax on the FMV of these stocks but, AFAIK, FMV stands for "Fair Market Value", so how can I determine FMV if there is no market for those stocks?
From the moment I received them until now, I couldn't and still can't
receive any cash for them. The hope is that they will be worth
*something* in the future.
What kind of evidence or documents would the IRS ask me to present should my claimed FMV be challenged? (remember, my agreement and all other documents related to that German startup are in GERMAN...)
You are practically asking for the impossible. Here in the U.S. a private company is obligated to determine the FMV of stock grants and stock options because of FASB pronouncement SFAS 123R and Section 409A of the Internal Revenue Code. There is no specific method identified in the rules and/or regulations. There are guidelines that discuss using similar companies in the same industry who are public; any sales of common or preferred stock to unrelated parties; internally prepared analyses using discounted cash flows; a "safe harbor" by using an unrelated third party to prepare the evaluation; a "safe harbor" allowing illiquid stock of start-ups to be evaluated in house using a certain set of criteria.
Based on my own experience 25 years ago when I was working in Silicon Valley and dealing with lots of start-ups, I can tell you that in many cases a stock without any public market and without any "readily ascertainable value" was valued at a penny a share when it was in the early stages of "start-up." This was a also a period of time that had no established guidelines.
You also need to be aware, that this has been a highly litigated issue relating to income tax, and estate tax valuation.
My advice is to first contact other employees or contractors who worked or who are working for the company in Germany and ask them if the company has performed an evaluation consistent with German accounting and tax rules. If you fail to obtain any useful data in this exercise, you just may have to use one penny.
For clarification, am I correct in assuming your "services" were provided in pursuit of a business you operate?
If that is correct, you presumably would have a normal charge which you would assess to a cash-paying customer. And that "normal" charge would have been accrued as at least a contingent earning for your business. That figure should be considered a starting point for establishing the "FMV" of the securities you accepted in return for your services.
In other words, you personally are the "Fair Market" for that stock -- and apparently the only one, at the present. That would give you a basis figure for the point at which the stock was delivered to you.
Now, if you're operating your business on a cash basis, you and your accountant will have to work out what income you declare for 2007 -- and fairly soon -- for this particular service. Whatever that amount becomes, would seem to be the FMV for the securities.
This is simply a logic problem, IMO, for the rather unique circumstance you face. It is possible that this compensation may be deemed _worthless_ (though you didn't provide it with charitable intent) ... in which case you will declare no income from that source in 2007. That would determine the stock's basis as -0- for some future occasion when you are able to sell it. That will satisfy the IRS, I believe, if you decide on that approach.
Hope these thoughts are useful.
This second question only arises if you have need to prove your cost basis. As stated above, you're the sole determinant ... so you could simply write a "memo to file" of your valuation, and that will of course be supported by your own business books. In other words, whatever you claimed in 2007 as income for the services, will become the basis.
Shouldn't she contact the company first? Probably Germany has an equivalent of IRS section 409A, so the company can say what the shares are worth (maybe par value of 0.01 EUR for a small company).
I agree the the value of small companies may be underestimated. Employees at startups get shares are 1 cents, 5 cents, 10 cents are share -- and three years later the company goes public at $30 a share.
But there was no cash income. Are you saying that if she normally works at $50 a hour and worked 100 hours, then the FMV of the stocks is $5,000; and if she got 1000 shares, then each is worth $5. That's too drastic in my opinion. The whole point of working for stock is to get lots of shares for practically nothing, so that if the company goes public one day, you can make a zillion.
I am almost certain that that German startup did not follow such rules... but I will check. BTW, that startup didn't sell anything yet... zilch. Only small investments from private persons.
You are describing an amazingly similar situation to mine. I am between a rock and hard place here (I wish I knew better when I signed that contract with them): On one hand, that German company was pretty sloppy in their practices (very atypical in that region I would say). On the other hand, if I declare any value that I wish, I will get in trouble with the IRS.
What is my best course of action?
I read elsewhere that "IRS challenges to valuations tend to be resolved in courts by the "battle of the credentials"-- so a key issue is to get someone with excellent credentials to value the shares."
My questions is: How and where do I find "someone with excellent credentials" that can value the shares in time for my tax preparation? Any ballpark figures for how much said professional charges?
I like the idea of one penny a share. The question is whether the IRS will like it, too. Of course, in due time I will have to pay tax on any gains on these stocks, but then there will be money with which I can pay...
My question now is: those gains, will they be taxed at a capital gain rate (most likely LONG TERM because I can't foresee in the near future any way to sell them)? Or will they be taxed at the regular type of income rate?
========================================= MODERATOR'S COMMENT: Please delete all unnecessary parts of a prior post when responding.
The amount declared as compensation becomes your cost basis for future capital gains.
Re your other questions..... I still advise you to contact other employees and/or the company CFO. In addition, there is a German equivalent to our FASB. As you may guess, it is called GASB (German Accounting Standards Board). You may want to contact them to find out what obligations a start-up has when they compensate employees with stock.
My business started not long before I entered into agreement with that German startup, so I do not have an established "normal charge" (yet).
Indeed, one month after I entered the company (and received my share of *minority* stocks), a private investor paid $50,000 in exchange for
10% of the that startup. Does that establish the FMV of *my* stocks?
If so, bear in mind that the main negotiation point for getting that $50K from that investor was my entry into the startup... In other words, before I entered into the company, its valuation (in the eyes of whoever they attempted to get money from) was much lower.
In fact, even now, after I invested significant amount of work and time into that startup, it is worthless without me continuing the work for at least one more year.
Does that call for a mess that no one can figure out or what? :)
I think that I need to pay a professional that can guarantee that the IRS will not challenge my tax filing, but where and how do I find someone like this? I believe that a "CPA only" is not enough here and neither a "Lawyer only", nor an "Analyst only". Is there such a professional who is both CPA, lawyer *and* analyst?
What am I to do? The IRS scares the hell out of me.
I do operate my business on a cash basis, but that doesn't mean that I can declare any FMV I want of those stocks, right?
Your thoughts are very useful and helpful. Had I known how much trouble this would entail, I would have not agreed to such form of "payment". Too late now. I need to find the least expensive way to get out of this.
Is it *that* simple? On one hand, I read (in this newsgroup and elsewhere) all kinds of things that scare the hell out of me. On the other hand you say (and I know that what you wrote is not binding in any way) that I am "the sole determinant". I am confused. What am I to do?
That is one way to estimate the value of the stock received, yes.
That's another way to measure the value. Too bad you didn't talk to a professional before you got into this. I would have suggested paying a nominal amount for the stock, based on the company's asset value at the time. That would have avoided this problem now.
What about the principals? What did they contribute on a per share basis?
The question of value comes down to, what would a willing buyer pay for the stock? You've indicated that there's an investor - what he paid was market value at that time, by definition.
No one can guarantee what you want. But many accountants are trained in appraising companies, and you want someone like that. If the IRS does ever challenge you, the accountant will have to show that his valuation was reasonable.
Actually, no. The IRS, and a court if necessary, will want to see objective evidence of value. That means, among other things, a list of assets of the company, a list of accounts receivable and payable, and comparisons to other companies in the same or a similar business. Your own normal billing rate and the number of hours you work for your stock will also be relevant.
Find a good accountant who can properly value your stock.
So what is an accountant going to do diiferently if there is not a market to buy this foreign stock? The instances I have seen similar to this in small private companies where someone exchanges their time for stock results in no income --
90% of these situations result in the company never being able to sell additional shares and eventually going out of business. value of shares received = zero or something very small.
His education and training will allow him to come up with a factual basis to base his opinion on. And if it is rational and reasonable the chances are the IRS will go along with it.
No doubt. But if it's worth a million dollars in a few years, do you want the IRS coming back then and claiming it was worth a lot more now? They're more likely to do that if you don't have a valuation they consider credible.
As we are dealing with a start-up located in Germany, I don't believe one is going to be able to find a readily available US CPA with the skill level and time to perform an independent appraisal that would conform to the proposed regulations under Sec 409A and SFAS 123R.
The best bet is to stick to German sources for information.
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