Startup companies should be aware of Section 83(b) of the Internal Revenue Code. Section 83(b) allows an employee who receives “restricted” stock to elect to have the fair market value of the stock included in income when it is granted rather than when it vests. Restricted stock is stock that is subject to a substantial risk of forfeiture and is nontransferable. The most common example of this kind of stock is stock that vests at a certain time, provided the employee to whom the restricted stock was issued is still employed by the company when the stock vests.
Armed with this knowledge, any company, but especially a startup company, can take advantage of the Section 83(b) election to generate potentially significant tax savings. Here is how it works.
- The value of restricted stock that is issued to an employee by the company as compensation for services is includible in his or her gross income either in the first tax year in which the shares vest (i.e., in which they are no longer subject to a substantial risk of forfeiture) or when he or she can transfer the stock free of the substantial risk of forfeiture, whichever occurs earlier.
- Under the Code, the employee can either do nothing at the time the shares are granted, and thereby defer the income attributable to the grant of the restricted stock until his or her rights in the stock become vested, or elect under Section 83(b) to recognize income at the time the stock is granted. In either case, it is the fair market value of the stock that is included in income.
- The advantage of accelerating recognition of the income to the date of grant is based on the assumption that the fair market value of the stock will increase over time and the fact that it is low enough at grant to make the accelerated tax liability acceptable to the employee.
- If the employee makes the Section 83(b) election, he or she will report income taxed at ordinary tax rates in the year the restricted stock is granted. Appreciation from the date of grant forward (less the employee’s basis in the stock) will be taxed at capital gain rates.
- If the employee does not make the Section 83(b) election, he or she will be treated as receiving income taxed at ordinary tax rates equal to the stock’s fair market value on the date the stock vests. Appreciation from the vesting date forward (less the employee’s basis in the stock) will be taxed at capital gain rates.
To illustrate, assume that a founder or key employee is granted 1,000 shares in Year 1 when the value of the stock is zero; the restrictions on the stock lapse in Year 2 when the stock is worth $16 per share; and the shares are sold in Year 3 for $20 per share.
If the employee does not make a Section 83(b) election, he or she will be taxed on:
- $16,000 in compensation taxable at ordinary income tax rates in Year 2
- $4,000 of capital gain in Year 3
- Maximum federal tax liability equals $7,288 ($16,000 x 39.6% plus $4,000 x 23.8%)
If the employee does make the Section 83(b) election, he or she will be taxed on:
- Zero in Year 1
- Zero in Year 2
- $20,000 of capital gain in Year 3
- Maximum federal tax liability equals $4,760 ($20,000 x 23.8%)
The benefit of the Section 83(b) election on these facts is maximized because the value of the shares at the date of grant is zero, meaning that none of the value of the shares is taxed at ordinary rates. However, if something appears to be too good to be true, it probably is, and as with all things tax-related, complexity is part of the landscape and potential pitfalls abound.
So let’s also take a look at some of the problem areas.
- Founders need to be aware that stock will not be considered subject to a substantial risk of forfeiture where the holder of purportedly “restricted” stock owns a substantial amount of the voting stock or other classes of company stock and thereby controls whether the possibility that the company will enforce the forfeiture restriction is substantial. Notably, sole or majority shareholding founders can stumble on this point. Non-founder key employees, on the other hand, rarely encounter this problem. Note, however, that there is also a provision in the Code (Section 1202) that reduces or eliminates the recognition of gain on dispositions of certain qualified small business stock—to be discussed here in a later Blog.
- Also, it is fairly common to establish a substantial risk of forfeiture by requiring that if the employee leaves the company before a certain date he or she must return his or her stock to the company. If the company must pay the employee the fair market value of the shares at the time he or she returns them, there is no substantial risk of forfeiture because nothing has been forfeited. If there is no substantial risk of forfeiture, a Section 83(b) election will be disregarded.
Most of the discussion to this point has involved founders and early-hire key employees—those who are involved with the company at an early enough stage to benefit from a low fair market value for the shares. Restricted shares that are issued at a time when the stock already has greater value, offer less benefit because if the employee makes the Section 83(b) election, he or she will pay tax at ordinary rates on the value of the shares at the date of grant and only the gain in the appreciation of the stock following the grant will be taxed at capital gain. There can still be significant value to making the election, but the results will not be as dramatic as illustrated above. Also, making the Section 83(b) election with respect to restricted stock that has value at the date of grant can complicate the Section 83(b) landscape in many ways, including the following:
- If the stock depreciates in value during the restricted period, the employee cannot deduct the amount included in income when he or she made the election. Also, the employee can only claim a loss on the stock when he or she sells it, and the loss will be subject to the capital loss limitation rules. For this reason, if an employee is uncertain whether the stock will grow or decline in value, he or she might consider not making a Section 83(b) election.
- If the employee actually forfeits the stock by failing to satisfy the vesting requirements, he or she cannot deduct the amount included in income when the election was made. And the employee cannot avoid this result by arguing that he or she misunderstood the forfeiture provisions and therefore should be allowed to revoke the election. However, the employee can claim a capital loss deduction for the excess paid for forfeited stock above any amount realized upon the forfeiture.
- The Company is required to withhold all applicable income and employment taxes at the time the fair market value of the shares is included in the employee’s gross income. In the event the employee makes the Section 83(b) election, applicable taxes for the restricted stock should be withheld from his or her paycheck following issuance of the restricted shares. In the event the employee does not make the Section 83(b) election, applicable taxes for the restricted stock should be withheld from his or her paycheck upon vesting of the restricted stock.
A Section 83(b) election must be made no later than 30 days from the date of the transfer. The employee must file the election in the form of a written statement with the IRS office at which the employee regularly files his or her tax returns and must send a copy of the election to the employer. The information to be included in the statement is specified in the Treasury regulations and can be obtained from your tax advisor.
So, looking back on all this and leaving the proper drafting of the restricted stock documentation and complying with Section 83(b) to your professional corporate and tax advisors, here is the essence of what you need to know: A Section 83(b) election will likely be more or less advantageous in the following situations:
|Section 83(b) election could be
|Section 83(b) election could be
|The value of the shares and, therefore, the amount of income reported at grant is small||The value of the shares and, therefore, the amount of income reported at grant is large|
|The potential for appreciation of the stock is moderate to strong||The potential for appreciation of the stock is low to moderate|
|The risk of forfeiture of the stock is very low||The risk of forfeiture of the stock is moderate to high|