Basic Tax Issues for Social Media Influencers

More interesting for our purposes is the social media influencer for whom "influencing" is a full-time passion. The most famous example is the Kardashian family, but there are many others.

What Is Income?

The tax concept of income is important in the social-media influencer world. Top influencers receive cash, equity, goods and services. What is taxable and what is not?

A useful way to think about income is to assume that everything you receive is taxable, unless there is an exception. Tax aficionados will cringe at this definition, but it is useful in practice.

For example, if someone transfers $1 million to an influencer's bank account, is that income? Yes, unless there is an exception to treatment as such. For example, if the $1 million is compensation from YouTube for revenues generated from the exploitation of the influencer's videos, that payment is taxable income. But if the $1 million is a loan from a bank or a gift from the influencer's parents, the money will not be taxable.

So two big exceptions from income are loans and gifts. A loan is not income because it is supposed to be repaid. If and when it becomes clear that the loan will not be repaid, the non-taxability argument disappears and cancellation of debt income frequently arises.

A gift is not income, although if it is large enough the giver will be obligated to file a gift tax return and even pay gift taxes. The concept of "gift" is frequently confusing to influencers, who wonder why the goods and services they receive are not tax-free gifts.

Suppose, for example, that an influencer enters into a contract with the Maybelline cosmetic company. The influencer is obligated to post about Maybelline products on an agreed-to schedule, for which the influencer will receive compensation. The influencer is so wildly successful that Maybelline sales go through the roof.  As a "thank you," Maybelline gives the influencer a Bentley. Maybelline is not obligated to give the influencer the car. It just does.

Is this a tax-free gift? It is made without any legal obligation whatsoever, so in the colloquial sense it is a gift. But it is not a gift for tax purposes. To be treated as a tax-free gift, the property must be given out of disinterested generosity. That does not exist here. Even though Maybelline is not obligated to give a Bentley to the influencer, the property transfer arises in the context of the influencer's business relationship with the company and cannot be said to have been made out of love and affection, or disinterested generosity, the cornerstones of a tax-free gift. Try explaining this to influencers who believe that everyone loves them and that it is perfectly natural for business relationships to give them gifts.

Equity

The treatment of cash transfers to influencers as compensation for their influencer activities is usually straightforward. The cash is almost always taxable upon receipt. But influencers get paid not just in cash but in other forms of property. The tax treatment of such property transfers is more complicated.

The most important type of non-cash consideration received by influencers is equity. "Equity" refers to an ownership interest in an entity, such as corporate stock, stock options, membership interests in LLCs, etc. Ever since the Internet boom, and despite the Internet bust, influencers and other talent have been chasing equity in hopes of hitting the jackpot. The fact that in many cases an equity play ultimately amounts to nothing does not deter those who seek to replicate the success of those very rare situations in which the underlying company is so successful that the equity granted to the influencer is truly life-changing.

Understanding the tax issues raised by taking equity is critically important when structuring equity deals for influencers. Frequently tax considerations drive the form of equity granted to the talent, as will be discussed below. In some cases, tax problems created by equity are so troublesome that they force the influencer to abandon equity in favor of taking an equity-flavored instrument instead, such as phantom stock, stock appreciation rights, restricted stock units, etc.

As described above you should assume that the receipt of equity is taxable, unless there is an exception. As it turns out, there are a number of important exceptions in connection with the receipt of equity. Some exceptions relate to timing; others are more absolute.

Stock

Suppose an influencer enters into a deal with a fledgling company hoping to distribute a new brand of bottled water. The influencer promises to promote the new brand on social media, in exchange for which the company will give the influencer one million shares of common stock of the company. Is this a taxable event to the influencer?

We start with the premise that compensation is taxable unless there is an exception, regardless of whether the compensation is paid in cash or property. There is no exception here. For example, compensation is neither a gift nor a loan. We thus must address the consequences straight on.

The first question is: What is the fair market value of the stock? The influencer will have taxable income equal to that fair market value (subject to certain vesting-related timing issues, discussed below).

Determining the value of stock is not always an easy task. Typically companies granting equity to influencers tend to be startup or early-stage companies that do not have equity that is publicly traded. There is no way to click on a link and learn the current trading price of the stock. Such companies are frequently very difficult to value. The company may not yet have generated a proven stream of income (or any income, for that matter) that might be valued based on a discounted cash-flow analysis. The company may also have no recent valuation benchmarks based on an investment in the company by an unrelated third party.

Difficulty in valuation does not mean that the valuation issue can be ignored. Tax arises even if it is exceedingly difficult to value the consideration. This means that you must take a more active role in determining value than you might otherwise care to do.

In particular, it is not a good idea to blindly rely on the valuation suggested by the company. If the company tells you that the stock is worth only pennies a share, the influencer is not excused from paying tax if it turns out that the stock is worth dollars a share. Remember that the influencer will have to dip into his or her own pocket to pay the tax on the value of the stock received. Influencers rarely want to do this, no matter how optimistic they may be about the future of the company engaging them.

Further complicating the matter is that frequently grants of stock or other equity to influencers are subject to vesting requirements. Companies don't like to make outright grants of vested equity because they want to be sure that the influencer is going to perform. Vesting restrictions have an important effect on the timing and amount of the taxable income to the influencer.

Suppose an influencer receives a grant of one million shares of common stock of a start-up corporation. The stock is 0% vested on the date of grant and vests 25% per year for four years. If she stops performing the agreed-upon services or otherwise breaches her agreement, she will forfeit any unvested shares. Suppose also that her stock is worth $100 on the date of grant, increasing to $100,000 on the first vesting date.

The tax law tries to help out service providers who receive unvested property by deferring the tax until the property vests. This seems eminently logical and fair: why should the influencer have to pay tax upon receiving something she may not get to keep?

As sensible as this may sound, in practice it can have terrible consequences. The influencer who receives the stock described above would have zero taxable income on the date of grant because none of the stock is vested. So far, so good, but look what happens on the first anniversary. Assuming that she is still performing her obligations under the agreement, she will vest in $100,000 worth of stock after one year. That means that she will have $100,000 of taxable income on that first anniversary, without having received any cash from the company with which to pay the tax. That is not going to be a happy situation for the influencer. And if she continues to work and vest, this will happen every year as the vesting restrictions lapse.

Fortunately, there is an easy solution to this problem under these facts: a §83(b) election. Section 83 is the Internal Revenue Code provision governing the transfer of stock and other property to service providers, including influencers. Making an election under §83(b) tells the IRS that rather than defer income until the vesting restrictions lapse, the influencer chooses to recognize taxable income on the date the stock or other property is transferred to the influencer, despite the fact that the property is subject to vesting.

In the abstract, making a §83(b) election seems contrary to one of the basic tenets of tax planning: defer the incidence of taxation whenever possible. All other things being equal, in a stable tax-rate environment you'd rather pay tax in the future, than now. But that is frequently not true in connection with stock grants, as the influencer example demonstrates.

If the influencer in our example makes a timely and proper §83(b) election, she will recognize $100 of income in the year the stock is granted. That's because the example assumes that the stock is worth $100 on the date of grant. She is likely to be untroubled by having to pay, say, $50 in tax as a result of the grant, because she will not have to recognize income when the stock vests each year. Using the facts of our example, the fact that the vested stock is worth $100,000 on the vesting date has no tax consequences. This is an extraordinarily favorable result.

The only catch is the making of the election itself. While it is simple enough to make the election, the election must be made within 30 days of the transfer of the stock or other property to the influencer. There are no exceptions. This is one of the many reasons why the influencer's tax advisor should be looped in at the earliest possible part of any potential transaction. In the example above, if the 30-day period passes without making the election, the influencer will be looking at paying a substantial amount of tax on phantom income each year that the stock vests. Heads will roll.

A §83(b) election is not always a good idea, though. In the example above, suppose the fair market value of the stock granted to the influencer is $50,000 on the date of grant, not $100. Making a §83(b) election will create taxable income of $50,000, which is likely to be an unacceptable result to the influencer. Not making a §83(b) election will also be problematic, creating phantom income each year as the stock vests. There is no good tax outcome under these facts, so what should the influencer do?

There is no ideal solution to this problem, but there are a number of approaches that may be workable, depending on the business deal and the influencer's desires and expectations. Each scenario assumes that the facts above make taking the stock itself unacceptable.

As discussed below, consider structuring the influencer's compensation as a different form of equity or even phantom equity.

Stock Options

The first solution is for the company to grant stock options, rather than stock. A stock option is the right to purchase stock for a period of time (say, 10 years) at a pre-set exercise price. If structured properly, the grant of the option will not be a taxable event to the influencer. Instead, when the influencer exercises the option, either by paying cash for the exercise price or taking advantage of a cashless exercise feature, ordinary income will be recognized to the extent the fair market value of the stock exceeds the exercise price.

For example, suppose an influencer is granted options to acquire 100 shares of stock of a corporation at an exercise price of $1 per share. In four years the value of the stock rises to $50 per share and the influencer exercises the options. She will pay the exercise price for the 100 shares — 100 times $1 = $100 — and receive stock worth $5,000 (100 shares worth $50 each). As a result of the exercise, the influencer will have taxable income equal to the value of what she received — $5,000 — less the price she paid to exercise the option — 100 — and will thus have $4,900 of taxable income.

Note that the income in this case is not accompanied by the receipt of cash. The influencer receives only stock when exercising the options. It is for this reason that influencers and other stock option recipients typically exercise their options only when they can sell the stock received as a result of the exercise, whether by virtue of a program created by the corporation, an IPO, a sale of the company or another event creating liquidity in the stock.

The tax consequences of stock options are in some important ways less desirable than those of stock itself. For example, with stock options, there is generally no opportunity for capital gain treatment. It is true that capital gain treatment should be available to the influencer if she exercises the option and then holds on to the stock for at least a year before selling it. Although the initial exercise will generate ordinary income, any post-exercise appreciation in the stock will be taxed as capital gains.

In practice, though, the capital gains play is illusory. As described above, in the vast majority of cases, influencers and other service providers exercise options only when they can cash out completely by immediately selling the stock received upon exercise. It is very unusual to exercise the option and hold onto the stock.

While the absence of capital gain treatment is a disadvantage of stock options versus stock, the fact that the grant of the option is tax-free usually far outweighs the obligation to pay tax on receipt of the stock or upon vesting.

How low can the exercise price be on the options? Typically, from a business standpoint options are granted at an exercise price equal to the fair market value of the stock on the date of grant. This assures that the influencer participates only in the growth of the company and not in its pre-existing capital value.

But the exercise price does not need to be as high as the fair market value of the stock on the date of exercise if two hurdles can be overcome. This is an important business consideration for the influencer because the lower the exercise price, the better the business deal.

The first obstacle, which usually is not a problem for influencers, is Internal Revenue Code (IRC) §409A. That Enron-era section typically imposes significant penalties if a compensatory stock option is issued with an exercise price that is less than the fair market value of the stock on the date of grant. But because an influencer is usually an independent contractor with respect to the issuing corporation, an important exception, §409A should not apply.

The second obstacle derives from the fact that the IRS believes that if the exercise price of the stock option is too low, the equity grant should be treated as a grant of stock rather than as a grant of an option. This creates the tax challenges discussed above for stock grants.

For example, suppose that an influencer is granted a stock option with an exercise price of $1 per share, on a day when the fair market value of the stock is $100 per share. The IRS is likely to say that because the exercise price is so low, for tax purposes stock has been granted, not an option.

How low is too low? A 50% discount should be absolutely fine. There is authority for a higher discount/lower exercise price, but some conservative planners prefer the safety of no more than a 50% discount.

Membership Interests in LLCs

The relatively recent surge in the popularity of limited liability companies means that entities offering equity to influencers are frequently LLCs rather than corporations. This is good news for the influencer because, through a quirk in the tax law, it is possible to structure a tax-free grant of an LLC membership interest to an influencer in exchange for services, while it is rarely the case that an influencer can receive a stock grant tax free.

The key is structuring the membership interest as what the tax law confusingly calls a "profits interest." It's a confusing term because many people upon hearing it believe that it refers to something akin to an interest in an income stream, rather than an ownership interest in an entity.

A profits interest is in fact a membership interest in an LLC, a membership interest that has certain specific characteristics. The key characteristic is that the membership interest must reflect only an interest in future profits, not in current capital. The membership interest must start with a zero capital account, so that if the LLC were to be liquidated immediately after the grant of the interest, the holder of the profits interest would receive nothing. If this basic requirement is satisfied, along with certain other minor requirements not pertinent to this discussion, the influencer will not pay tax on receipt of the membership interest.

What if the membership interest is not fully vested on the date of grant? Then the influencer should make the IRC §83(b) election discussed above, reporting a zero value to the purchased interest. This zero valuation is approved by the IRS, a surprising result because most membership interests have at least some value, even if nominal.

The IRS has indicated that if certain requirements are satisfied, a §83(b) election is not required. My own preference is to make the election regardless, because the satisfaction of at least some of the requirements can't be known until after the grant date.

Phantom Equity. "Phantom" equity is like "constructive" receipt; both words mean "not." Phantom equity is not equity. It is not stock or a stock option or a membership interest or any form of ownership of the issuing corporation. It's just a promise to pay cash.

Common examples include phantom stock and stock appreciation rights. Phantom stock generally refers to a compensatory arrangement whereby a service provider is promised a payment in the future equal to the then-fair market value of a number of shares of the issuer's stock. A stock appreciation right is similar, except that the payout is based on the increase (if any) in the value of the stock since the date the right is granted. In both cases, the ultimate consideration paid will be cash, although the amount of cash will be in each case measured by the value of the underlying stock.

There are other many other types of equity and phantom equity. Variations are designed to achieve particular business objectives.

Unlike stock or LLC membership interests, phantom equity does not provide the opportunity for the recipient to receive capital gains treatment. Payouts are ordinary compensation income. Still, phantom equity is preferable to actual equity in circumstances in which the receipt of actual equity would result in the recognition of taxable income without the receipt of cash sufficient to pay the tax.

Probably the most important take-away from this discussion of equity compensation is to consult with a tax expert when structuring compensation for influencers. What may appear to be a great economic deal — such as the receipt of stock — might carry with it some untenable tax consequences. It is much better to address these issues at the outset rather than just before signing (or worse, after signing).

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Bob Jason is a Partner with NKSFB LLC, a leading business management and accounting firm based in Los Angeles and New York. He is also a member of the Board of Contributing Editors of  the AFP's sibling LJN newsletter, Entertainment Law & Finance. Bob graduated from Harvard, where he majored in mathematics, and Harvard Law School, where he was an editor of the Harvard Law Review. This article © 2019 Robert M. Jason. All rights reserved.