Startup companies often seek to retain their founders and critical employees through the use of equity compensation. To ensure that these top people are committed to the company for the long-term, it is often a good idea to issue stock subject to buy-back provisions (founder’s restricted stock). However, shareholders must be careful to follow strict IRS guidelines to ensure their investment receives the most favorable tax treatment.
A typical founder’s restricted stock transaction grants the founder (or employee) stock compensation but reserves a right for the corporation to buy back any stock that is “unvested.” Initially, most of the stock is unvested, giving the corporation the ability to buy back the stock if the employee leaves. Each year a percentage of the stock initially granted to the employee “vests” and the company loses its right to repurchase those shares. Eventually, if the employee remains with the company, all of the restricted stock will vest.
The shareholder can elect to have his shares taxed in one of two ways by either filing or not filing what is called an 83(b) election. First, if no election is made, the value of the restricted stock is not taxable to the recipient until the stock vests. Once the restrictions lapse, the current fair market value of the shares, minus any amount paid for the shares, is taxable as ordinary income in the year the stock vests. Alternatively, under Section 83(b) of the Internal Revenue Code, the shareholder can elect to be taxed on the value of all shares (including unvested shares) at the time of receipt. Although each option has its benefits, there are several factors that weigh in favor of making the 83(b) election.
The table below briefly summarizes the relevant aspects both choices:
With 83(b) Election
• Value of restricted stock (minus any payments for the shares) is taxable as ordinary income in the year shares are received.
• Share appreciation is taxed upon sale at capital gains rates.
• Dividends on all shares are taxed at the preferential dividend tax rate.
• No deduction is allowed if share value decreases.
• Shareholder controls timing of gain recognition (upon sale of shares).
• Holding period begins upon receipt of shares.
Without 83(b) Election
• Value of restricted stock is not included in income until the restrictions lapse (the stock “vests”).
• Share appreciation is taxed at ordinary income rates and is recognized when the shares vest. This can cause problems for the founder because he may incur substantial tax liability but not be able to sell the stock to generate the cash to pay the taxes.
• Dividends on restricted shares are taxed as compensation (but are deductible to the corporation).
• Shareholder does not control timing of gain recognition (taxed as ordinary income on value of shares once stock vests).
• Holding period does not begin until the share restrictions lapse (the stock “vests”).
The ideal scenario for an entrepreneur to make an 83(b) election occurs when the founder pays fair market value for the restricted stock, and the share value is expected to increase over time. This situation leaves the shareholder paying no or minimal tax upfront, but enables the shareholder to control the timing of future gains (upon the sale of stock) and affords capital gains treatment rather than ordinary income. Getting an attorney involved at the time of company formation can ensure that the founders can take advantage of this tax planning opportunity.
If you decide that making an 83(b) election is right for you, then be sure to file the appropriate notice with the IRS within 30 days of the receiving the restricted stock—there is no grace period. The IRS does not provide a specific form, but the election must be in writing and filed with the Internal Revenue Service Center where you file your return. IRS Publication 525 provides specific details regarding 83(b) elections.
You should get in contact with your attorney if you have questions about whether the issues discussed in this post apply to your or your employees’ compensation arrangements.