For entrepreneurs, startup founders and company executives, restricted stock grants have great potential for enormous tax wins and some risk of costly loses.
Restricted stock is typically granted to company founders or executives, with the same voting rights as other shareholders, but with restrictions. Specifically, the stock is subject to forfeiture or repurchase by the company until it fully vests along a time-based schedule.
Properties of typical restricted stock grants include the following:
Restricted stock grants are taxed as any other income earned for services, at the typical income tax rate in the year the stock is vested. The tax owed is based on the fair market value at the time of vesting.
Tax = (Fair market value of stock) – (original purchase price [which can be zero])
Since restricted stock often vests over a period of time spanning several years, the grantee would have to report a tax gain in each year when additional stock vests. Should the company do really well as the stock vests, the amount owed in taxes every year would increase with the increased of value of the newly vested stock.
This potentially huge tax liability can spell bad news for the company founder or executive.
As a way to limit this tax risk, grantees might consider filing for the 83(b) election [26 U.S.C. § 83(b)] with the IRS.
Filed no later than 30 days from the initial grant date, the 83(b) election allows grantees to pay the tax on the full restricted stock grant up front at the present day value of the stock (for startup companies, this value is often close to pennies per share).
Although taking the 83(b) election may sound like a great solution, its efficacy depends on certain situations.
If the grantee is a founder or key employee of a startup company whose stock does not hold much value.
The tax on stock of virtually no value is virtually zero = Win.
If there is a large span of time between when the stock is granted and when it vests.
Avoiding the probability of stock growing in value over a long period of time = Win.
If an 83(b) election is timely made, the grantee would only pay tax again during a stock liquidation event (when the grantee sells their stock) where the “spread” between the stock value at the time of grant and the value at the time of sale would be taxed at the capital gains rate. This is much lower than the typical income tax rate.
If the company stock falls in value.
In this case, the grantee has prepaid their taxes via 83(b) but the IRS will not issue a refund = Loss.
If the grantee leaves the company before the stock is vested.
Restricted stock is subject to forfeiture, regardless of whether taxes have been prepaid = Loss.
The grantee may, however, claim a deduction for the capital loss.
Capital gain/loss= (Sale price after vesting) – (fair market value on date of vesting)
In sum, the gain or loss of filing an 83(b) election is somewhat of a gamble based on the projected circumstances of the grantee as well as the company.
Filing an 83(b) election on nominally valued stock is a no-brainer given that the tax payment made to the IRS is so small, it would not burden the grantee too much if the stock never vested or the company never did well enough to significantly appreciate in value.
Filing an 83(b) election on stock granted in a higher value company is a much more risky proposition because the corresponding tax payment would be significantly higher. In that case, the question becomes whether the grantee prefers to pay a certain amount in taxes in the year of grant versus a potentially increasing value of taxes over the entire vesting period.
If you have questions about 83(b) elections, restricted stock grants, or other corporate matters, please contact Benjamin S. Thompson or any member of the Thompson Bukher Business & Corporate Practice at (212) 920-6050.
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