How Stocks Are Taxed Under 83(a) and 83(b): Why You Should Call Your Tax Advisor
Startups will often use stock to compensate founders, key employees, contractors, and advisors for their services.
The general rule under Section 83(a) of the Internal Revenue Code is that stock given in exchange for services is considered taxable compensation at the time it is received, just as if it were cash. As such, it would be reported on an employee’s W-2 or on Form 1099-Misc for non-employees.
However, stock issued to employees (or advisors) of early-stage companies often has restrictions before the full rights of ownership are transferred (vested). For example, shares could be subject to a vesting schedule causing shares to transfer at the end of each of four years in equal amounts instead of vesting all at once.
When shares are issued with certain restrictions, the shares are not taxable until these restrictions are removed and the holder has the full right to sell or otherwise do as he or she pleases with the shares.
However, when stock is issued with restrictions, the IRS has provided another option under Section 83(b) that is worth consideration.
Election to Include Fair Market Value in Gross Income in Year of Transfer
With the 83(b) election, the employee (or advisor) receiving the shares may elect to be taxed in the current year on the current fair market value of 100 percent of the shares received rather than in subsequent years when the restrictions are removed.
The employee must file the election with the IRS within 30 days of receiving the restricted shares to elect Section 83(b). This is why it is very important to understand the implications of Section 83(b) before you grant or receive restricted shares of stock as compensation.
Tax Basis of Stock at Early Stage May Be Less than When Company Grows
For an employee receiving shares of an early-stage, high growth company, the tax savings from an 83(b) election may be significant. Because the early stage fair market value of shares likely will be at its lowest when the high-growth company is first established, it often makes sense for founders and employees receiving restricted shares to make an 83(b) election in the very early stages of the company.
Another benefit of making the Section 83(b) election is that the 12-month clock for long–term capital gains begins the date when the election is made.
Whether an 83(b) election is made or not, there likely will be additional tax consequences from stock received as compensation. Look at both the total tax liability and the timing of the tax liability when evaluating the 83(b) election.
Consider the following:
- What is the value of the restricted stock when granted?
- What is the potential growth in the value of the restricted stock?
- When will you have the money with which to pay the tax owed? It’s unlikely that you will be able to sell equity that isn’t publically traded to pay the tax liability either when the stock is initially given or as it vests.
- The 83(b) election creates an immediate tax liability. Based on the current fair market value of the shares received, you must pay the estimated tax liability when the shares are issued.
- If you do not make the 83(b) election, you will have a tax liability as the restrictions are removed from the shares (i.e. when the shares vest). Based on the estimated future fair value of the shares when they vest, will you have the money to pay the tax owed?
Remember, the 83(b) election must be made within 30 days of receiving the grant of restricted stock. There are no exceptions to this rule.
A sample letter of the 83(b) election and the requirements of the letter can be found at http://www.irs.gov/irb/2012-28_IRB/ar12.html#d0e3012.
The details of each situation will determine whether the 83(b) election should be made or not. Each individual should consult* with his or her tax advisor on this specific consideration before the company is incorporated and stock provisions are set.
*Consult Your Tax Advisor
We are not tax advisors and are not offering tax advice. This discussion is based on current IRS publications. We do recommend that entrepreneurs and startup companies always consult their tax advisor and attorneys on the specifics of their situations, any tax-related matters, or to learn more about the subject discussed in this article.