The principle, the framework, the audit object

Formally, for an issuer $i$ over an interval $[t_1, t_2]$:

Each income event $j$is evaluated against two tests (next section). If either passes, the income is in; otherwise it’s out. The inclusion is a binary: TEB does not have partial weights for “mostly labor-derived” income.

Why it matters —The principle approach replaces an enumerable list with a decidable test. Lists become out of date the moment a new income type appears (DAOs, content royalties, AI-revenue shares); the principle stays valid because it’s framed at the level of economic causation, not instrument enumeration.

Test 1 · Labor origination

Does the income arise from labor — current, past, deferred, or in-kind — performed by the issuer?

Test 2 · Asset origination

Does the income arise from an asset that exists because of the issuer’s past human capital?

Why it matters —Both tests are inclusive: if either Test 1 or Test 2 passes, the income is in TEB. Most income events pass at most one test cleanly; the framework rarely needs both.

The principle is unambiguous, but enforcement against gaming requires explicit closures of four common evasion paths:

1 · C-corp parking

Attempted dodge: route labor income through a wholly-owned C-corp; the C-corp retains the cash; the issuer takes minimum salary. TEB looks small.

Resolution — IRC §542 personal holding company look-through: if the C-corp is a personal holding company under §542 (60%+ of AGI from personal-services contracts), look through to the underlying labor income. Retained earnings count as deferred TEB accruing in the year earned, not the year paid.

2 · Deferred comp games

Attempted dodge: structure compensation as deferred-comp arrangement maturing post-covenant. Pre-covenant earnings spike, post-covenant the deferred amounts vest tax-free to the covenant.

Resolution — IRC §409A constructive-receipt accrual: treat deferred comp as received (and counted in TEB) at the point of constructive receipt, which under §409A is generally when the substantial risk of forfeiture lapses. Vesting schedules accrue TEB at vest, not at payout.

3 · Alpha bifurcation (PM / hedge fund managers)

Attempted dodge:portfolio manager bifurcates their personal trading book from their hedge-fund book; claims the personal trading is “just investment” and out of TEB.

Resolution — filed-benchmark rule with default-zero: for any active-management role, the issuer must declare a benchmark (e.g. S&P 500 + 200bp) at listing; alpha above the benchmark on personal capital is in TEB. If no benchmark is filed, default to zero alpha attribution (i.e., all returns treated as LP-style passive) — which leaves the bifurcation dodge with nothing to hide behind on the firm side.

4 · Inherited dividends bifurcation game

Attempted dodge: declare an inherited business but never separate pre-vs-post involvement; claim all dividends are inherited (out of TEB).

Resolution — basis-ratio bifurcation rule: the inherited portion of cash flow equals (basis at inheritance) / (basis at present) of dividends. The issuer must document the two basis values with valuation reports; any unsupportable basis is treated as zero-pre-involvement and 100% TEB.

Death or permanent incapacity

Phase 1: covenant terminates; tokens convert early to a Phase 2 stake against the estate’s ongoing TEB (royalties, trust distributions). Phase 2: standard succession — claim continues against ongoing TEB. Not a total-loss scenario for backers.

Stopped working (minimum-effort floor)

Issuer “retires” mid-Phase 1 and TEB drops to zero while issuer is still capable. Covenant-level governance: a minimum-effort floor applies (e.g., median TEB of trailing 3 reporting periods, or sector-conditional median). Backers can invoke the deficiency-and-cure framework. This is a covenant-level governance question, not a lock-level one — see pre-IPO lock spec, edge cases.

Joint filers

Married filing jointly: covenant is with the individual, not the household. Spousal income is excluded; issuer’s portion of joint income (W-2 line, K-1 K1-line) is in. Schedule C and Schedule E entries are individual-attributable by default.

Equity compensation timing

ISOs/NSOs: TEB accrues at vest (not at grant) at FMV-on-vest. ISO exercise pre-AMT: AMT-adjusted spread counted in year of exercise. Sale at later date: appreciation between vest and sale is capital-gains return, not TEB.

Non-cash consideration

Tokens, equity, perks above IRS thresholds: counted at FMV at time of receipt. Subsequent appreciation/depreciation is capital gain, not TEB.

TEB is gross of personal taxes but net of legitimate business expenses for self-employed and pass-through entities. The distinction:

• —Personal taxes (federal income, FICA, state) are not deducted from TEB. The covenant’s share rate is computed on gross income; this matches how creditors and ISA originators have historically operated.
• —Legitimate business expenses (Schedule C deductions for COGS, equipment, contractors) are deducted. The economic activity that produced the income required these expenditures.
• —Salary parked in a personal C-corp is in TEB pre-deduction (under the §542 anti-dodge rule above). Issuer can’t deduct “salary to themselves” to escape the covenant.

The three layers move from principle to evidence to legal backstop. A discrepancy between the operational layer (what the issuer reports quarterly) and the enforcement layer (what the tax return shows) triggers the deficiency-and-cure framework.

The framework is principle-grounded, so it ports across jurisdictions, but the two-test mechanics rely on US tax-code definitions (IRC §542, §409A, §475(f)). For non-US issuers:

• —The issuer’s home jurisdiction’s analogous code provisions are used (UK SA-100 + CT600, Canadian T1 + T2, EU PIT regimes, etc.)
• —Currency conversion uses the daily IRS reference rate at end of reporting period
• —Cross-border issuers (US tax resident with foreign-source income) follow US treatment for the covenant
• —Specific country supplements maintained by Preflop’s legal team and posted on listing approval

Complete derivations, every edge case, every anti-dodge rationale, and the international supplement live in PreFlop/wiki/The-Math-Theoretical-Foundation.md Part 1.1.