83(b) Election & Stock Options - Explained
What is an 83b Election for Stock Options?
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Table of ContentsWhat is an 83(b) Election for Stock Options?Example of an 83(b) Election SituationVesting Schedule and Restricted SharesTax Consequences of Section 83(a)Benefits of Section 83(b)What Happens If I Miss and 83(b) Election?Remedies for a failure to Make an Section 83(b) Election
What is an 83(b) Election for Stock Options?
IRC Section 83(b) allows a shareholder receiving stock for services that is subject to a substantial risk of forfeiture to recognize the value of the stock as income in the year distributed. This allows the shareholder to recognize the stock as income before the stock increases in value. This is incredibly valuable for startup entrepreneurs who expect rapid growth of the corpora4on and value of the shares of stock. The risk associated with making an IRC Section 83(b) election is that the value of the stock will decrease, as there is no subsequent deduction allowed to the taxpayer. In such a case, the shareholder incurs income tax on the higher value.
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Example of an 83(b) Election Situation
Sarah agrees to work for the corporation in exchange for salary and an equity holding in the company. She will receive 1% ownership stake in the company at the end of each year for 3 years (her vesting schedule). If she leaves the company prior to the end of 3 years, all of her stock interest is forfeited back to the corpora4on. The contingency that Sarah stay at the company 3 years before owning her equity interest constitutes a substantial risk of forfeiture. Under IRC Section 83(a), Sarah can defer recognition of the stock award as income until the end of year 3. If, however, she chooses to recognize the stock award as income at the time that it vests (at the end of each year), she can elect to do so under IRC Section 83(b). Electing to recognize the income in the year awarded may lower her tax liability, as the stock will likely rise in value. If she waits until the end of year 3 to recognize the total value of the vested stock, she will pay income on the present value of the stock at that time.
- Note: Shareholders may not want or be able to pay the taxes on issues of stock for services, as she does not receive any cash along with the stock. In such a case, the shareholder may negotiate with the corporation to provide a bonus, known as a gross up payment, to cover the taxes on the value of the stock received.
Vesting Schedule and Restricted Shares
Stock grants are contract that contain numerous provisions. In most cases, the employee receiving the stock as compensation may not fully own the stock granted to them. That is, stock granted to employees is often subject to restrictions and a vesting schedule. This means that the stock cannot be immediately sold. If it cannot be immediately sold, it shareholder cannot cash out of the stock. Also, the shareholder to does not become full owner of the stock until it vests in them. The stock will generally vest along a timeline (generally over 4 years) or upon the company meeting certain performance metrics. Also, often times, none of the stock will vest until a specified period of time has passed. Once that period has passed (generally 12 months), a specific percentage of the stock will vest (generally 25% of stock granted). This is known as a “cliff”. The purpose of this arrangement is to make certain an employee stays with the company and remains loyal after receipt of the stock grant. It would not be good for the company for the employee to immediately leave the company holding the stock.
Tax Consequences of Section 83(a)
Restricted equity that is subject to a vesting schedule will not vest ownership in the member until some time in the future. The effect of the member’s equity ownership being subject to risk of forfeiture (restrictions and vesting schedule) is that, under Section 83(a) the employee does not immediately recognize the equity grant as income. The thinking is that the member is not full owner of the equity. This is a real problem if the employee assumes that the value of the equity awarded is going to rise. The reason regards taxation.
Any increase in the value of an equity holder's (business owner's) interest is not subject to taxation until or unless the stock is sold or traded. This allows for tax deferment (until sale). If the equity is subject to vesting, the employee is required to recognize the value of the equity as income at the time that it vests. This means that, if the equity has risen in value since the time of grant, the employee must recognize the higher value as income at the time of vesting. This is not favorable, as the amount of taxes on income is generally higher than the taxes on capital gains. Further, this option does not allow for deferral of taxation until the equity is sold.
Benefits of Section 83(b)
The savior for the employee is IRC section 83(b). This provision allows the employee to elect to recognize the full value of the granted equity immediately. That is, the employee does not have to wait until the equity interest fully vests to recognize the value of the equity as income. Thus, the employee recognizes the equity as income when it is lower in value. When it rises in value in the future, it is taxed at a capital gains rate and it is not taxable until the equity is sold.
What Happens If I Miss and 83(b) Election?
Many employees receive stock as a form of compensation. Often the employee does not receive immediate ownership of the stock; rather, ownership of the stock vests in the employee at a specific time in the future. The employee may have to satisfy certain conditions or milestones for the stock to vest. This might include working for the company for a specific period or meeting certain performance criteria. The typical vesting period for a startup company stock is four years. Visit the LawTrades blog to learn more about stock grants.
An employee is not deemed to have received compensation for tax purposes until the time that ownership of stock vests. Vesting occurs when conditions are satisfied or, if earlier, at the time the employee can transfer the stock to a third party with the third party not being bound by any risk of forfeiture. This is not always a preferable outcome for the employee. If the stock rises in value between the time of the stock award and the time that it vests, the employee will ultimately be subject to income taxes on a larger amount of compensation. This problem is made worse when there are restrictions on the sale of the stock. So, the employee may not be able to sell the stock to cover the tax obligations at the time the stock vests. As such, employees would often prefer to recognize the stock as income at the time the stock is awarded. Paying income taxes on the stock at the earlier time and lower valuation results in lower taxes.
Generally, the employee would pay income tax on the stock at the time it is awarded. If the stock increases in value, the employee will not be subject to taxation on that increase in value until she sells the stock. At that time, she would be subject to capital gains tax on the amount that the stock increased in value. The capital gains rate is generally lower than the personal income tax rate, and such compensation is generally not subject to Medicare and Social Security taxes.
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Remedies for a failure to Make an Section 83(b) Election
If an employee finds herself in the unfortunate position of failing to make the 83(b) election, there are a few options she can attempt to remedy the failure.
- Quit Your Job - One option is to quit your job and stop the stock from vesting. You can arrange for the company to rehire you under conditions that allow you take advantage of available tax deferment. Of course, there is always a risk in this situation that it looks like fraud to the IRS or that the company later refuses to rehire you.
- Immediate Vesting - Another option is to have the company amend the stock issuance to make the shares vest immediately. This would cause tax liability on the current fair market value of the shares. Of course, the company may not be willing to immediately vest the shares. This would defeat the purpose of the shares being subject to vesting in the first place.
- Company Repurchase - Another option is to transfer the unvested shares back to the company. The company could then re-issue new shares to you. The only downside is that, if you make the 83(b) election, you will be taxed at the fair market value of the shares at the time that the new shares are issued. Also, there is a possibility that the IRS will not recognize the re-issuance.
- Change Company Repurchase Value - Another option is to amend the stock grant to require any repurchase of the unvested stock by the company to be at fair market value, rather than the value at the time of issuance. If the company is required to repurchase any unvested shares if the employee leaves or a condition for vesting is not met, the IRS treats it as if there is no “risk of forfeiture”. Therefore, the stock grant is immediately taxable as compensation. Again, the company may not be willing to accept these conditions.
- Corporate Governance Defect - Another option is to argue that the stock grant was not legally effectuated. This could be the case if the board fails to follow governance procedures in issuing the stock. This would allow the board to reissue the stock using appropriate procedures. Such event would allow for the 30-day clock to start anew.
Third-Party Transfer - Another option is to verify the conditions restricting transfer of the stock. Some employee stock restrictions provide that the employee can transfer shares to a third party even if the shares are not vested, but that the employee (and not the employee’s transferee) will be obligated to reimburse the employer if the employee fails to satisfy the vesting conditions. If these conditions are not present, it may be possible to amend the stock grant to allow for such a transfer. If the stock meets these characteristics, the employee may be able to arrange a transfer or sale of the stock to allow immediate recognition as income. There is also an argument that the shares are no longer subject forfeiture if these conditions are present, even if the employee does not actually transfer the shares. The stock would then be subject to tax at the value of the shares at the date of amendment to allow transfer.
Note that you cannot legal backdate or alter old paperwork. This would be illegal. Taking steps to amend the characteristics of the stock grant may be permissible under state law.