Contractors, advisers, and employees (collectively, “Service Providers”) who receive property that is non-transferrable or subject to a substantial risk of forfeiture must generally defer their income recognition until those conditions no longer apply. However, due to the potential appreciation in the property (for example, in value of start-up equity) the ordinary income ultimately recognized could be significantly greater than the initial value. The Service Provider may be able to significantly reduce their taxes, and the employer may create a significant compensation incentive, if the Service Providers make the election under Internal Revenue Code Section 83(b) to recognize the income currently, notwithstanding the forfeiture risks. Timing of this election is critical as it must be made within 30 days after the property is transferred to the Service Provider.

Under Internal Revenue Code 83(a), Service Providers who receive property (including equity interests) for their services that are non-transferrable or subject to a substantial risk of forfeiture are required to pay, at the date the interests vest, income tax on the excess of the fair market value of the property over the amount paid for the property. If the fair market value of the property increases between the grant and vesting of the interests, Service Providers will pay an income tax on the greater value, and possibly at a higher marginal rate too. A Section 83(b) election may be the perfect tool for Service Providers to convert immediate ordinary income into deferred long term capital gains.

The downside of the election is that the income is recognized even though the risk of forfeiture still exists. If the risk materializes and the property goes down in value, or becomes worthless, there is no deduction to the Service Provider. They are stuck with paying income tax on property that is potentially worthless.

These risk/reward tradeoffs highlight the advantage of using this election for compensating employees of start-up ventures, typically with equity subject to vesting. In this case, the current value of the equity is limited, so there is little or no income to report (and pay tax on) currently. If the equity goes down in value, or is forfeited, the employee has not wasted tax payments. However, if the equity increases in value, as the parties hope, then the employee will be able to report this value at the more favorable capital gains rates instead of ordinary rates. The Section 83(b) election can make a start-up equity grant a much more effective inducement to attract new employees, by putting more money into the pocket of the employee.

But remember, taking advantage of the Section 83(b) elections requires a filing by the Service Provider within 30 days after the grant of property. The law does not want to allow the Service Provider to see which way the value is moving. The election, and the commitment to property must be made up front.

Service Providers should contact an attorney or other tax professional when deciding whether or not to make a Section 83(b) election. Additionally, issuers and companies should contact Cole Schotz P.C. before granting equity or other compensation.

The SEC’s recently-adopted changes to Form ADV and Rule 204-2 of the Investment Advisers Act of 1940, as amended (the so-called “books and records rule”), raise important considerations for many private fund advisers – particularly those that also advise separately managed accounts or that manage multiple funds through affiliated entities.

In particular, the amendments will: (1) call for the collection of more specific information about advisers’ separately managed accounts (“SMAs”), (2) permit so-called umbrella registration on a single Form ADV for affiliated advisers that participate in a single advisory business, and (3) impose several new disclosure and recordkeeping obligations on advisers.

The SMA-related amendments include the following additional disclosure items:

  • Approximate percentage of SMA regulatory assets under management (“RAUM”) that are invested in 12 broad asset categories;
  • For advisors with at least $500 million in RAUM attributable to SMAs, the amount of RAUM attributable to SMAs and the dollar amount of borrowings attributable to those assets; and
  • Certain information about custodians that account for 10 percent or more of the adviser’s aggregate RAUM attributable to SMAs.

The umbrella registration-related amendments essentially modernize Form ADV to accommodate this form of registration and streamline the registration process consistent with the SEC’s position in the recent American Bar Association, Business Law Section, SEC Staff Letter (Jan. 18, 2012).  Note that these amendments do not extend to exempt reporting advisers and that certain conditions must be met in order for registered advisers to utilize umbrella registration, including:

  • The filing adviser and each relying adviser must advise only private funds and separately managed accounts in which the clients are “qualified clients”;
  • The relying advisers must be subject to examination by the SEC; and
  • The filing adviser and the relying advisers must operate under a single code of ethics and a single set of written compliance policies, and the procedures must be administered by a single CCO.

Separately, the amendments to Form ADV will call for new disclosures about advisers’ social media accounts, offices, and outsourced chief compliance officers (an area of recent focus by the SEC), among other things.

In conjunction with the amendments to Form ADV, the SEC also revised the books and records rule to require that advisers retain materials that demonstrate the calculation of performance or rates of return in any communications distributed to any person, as well as to maintain originals of all written communications received or copies of all written communications sent that relate to the performance or rate of return of managed accounts or securities recommendations.  Note that emails constitute “written communications” for these purposes.

Although the amendments to Form ADV and the revisions to the books and records rule do not go into effect until October 1, 2017, private fund advisers should consider what steps they should be taking now in order to be in a position to comply with these new requirements before the time comes.

The final rules are available here.

Earlier this month, the Securities and Exchange Commission approved amendments to, among other things, revise the rules related to the thresholds for registration, termination of registration, and suspension of reporting under Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”).

The amendments, include establishing:

  • a higher threshold of (1) a minimum of $10 million in assets; and (2) 2,000 holders of record or 500 holders of record that are not “accredited investors” for an issuer to be required to register a class of equity pursuant to Rules 12(g)(1);
  • a higher threshold of 300 holders of record (or 500 holders of record, if total assets have not exceeded $10 million) below which an issuer may terminate registration under Rule 12g-4(a);
  • a higher threshold of 300 holders of record (or 500 holders of record, where if the issuer’s total assets have not exceeded $10 million) below which an issuer may suspend Exchange Act reporting under Rule 12h-3; and
  • flexibility in calculating securities “held of record” for purposes of determining registration requirements under Exchange Act Section 12(g) by permitting the exclusion of certain securities held by employees and other persons who receive them under employee compensation plans exempt from Section 5 of the Securities Act and establishing a non-exclusive safe harbor for determining securities “held of record” for purposes of Rule 12g5-1.

Thresholds were also amended for banks and savings and loan holding companies.

These amendments implement provisions of the Jumpstart Our Business Startups Act (JOBS Act) and the Fixing America’s Surface Transportation Act and completes the rulemaking mandated by the JOBS Act. These rules generally harmonize the SEC rules with the statutory changes to the Exchange Act.

The amendments will become effective on June 9. 2016. The final rules are available here.