Tax Treatment of Equity Compensation

Federal and state tax codes can take a big bite out of your company’s equity compensation. That’s why founders, executives, and employees of start-ups should understand the role that Internal Revenue Code Section 83 plays in the tax treatment of equity compensation that is given in exchange for services.

Most startups use equity incentives instead of cash, at least in part, to pay for services from employees, contractors and advisers. When the equity incentives take the form of equity grants (e.g., stock, options, units, etc.), and the grants are subject to vesting, Section 83 can be the service provider’s best friend or worst enemy. Here’s what you should know about Section 83 and how to use it.

Example: Assume a startup grants employee 100,000 shares of stock. 25,000 shares vest one-year from the date of the grant; a common one-year cliff. Assume the shares have a fair market value of $0.05 per share on the date of grant. Assume the value of the shares is $0.25 per share at the end of year 1, $0.75 at the end of year two, $2.00 at the end of year 3 and $5.00 at the end of year 4.

What could be the problem? Glad you asked. Section 83(a) would require the above equity grant to be taxable at the fair market value of the shares as of the respective vesting dates, not the grant date. The table below shows how this generally works:

So, if the employee has an effective federal income tax rate of 30 percent, he or she will pay a total of $60,000 of federal income tax as a result of the grant. Why?

In general, Section 83(a) provides that if property is transferred to a person in connection with performance of services, the service provider receives compensation (i.e., ordinary income) in an amount equal to the excess of the fair market value of the property received, over the amount paid for such property, if any, by the provider. When, however, the property received by the service provider is subject to a substantial risk of forfeiture or is not transferrable (“restricted property”), the service provider doesn’t recognize income on the property until it vests (i.e., when the restrictions lapse). When restricted property received by a service provider vests, the service provider will be required to pay income tax on the amount by which the fair market value of the property exceeds the amount paid for such property, if any, as of the date of vesting. In the case of restricted stock and other equity, there may be substantial appreciation between the grant date and the date of vesting, in which case, the service provider will be required to pay income tax on such appreciation at ordinary income tax rates.

Section 83(b) provides an alternative approach that is generally more favorable than the result under Section 83(a). However, this will not always be the case as noted below.

Under Section 83(b), the employee in our example is permitted to make a so-called “Section 83(b) election.” If the election is made, the employee will be required to recognize as income the fair market value of all of the granted shares as of the date of grant, rather than the date of vesting. In our example, the fair market value of the shares on the date of grant is $0.05 per share. Applied to the total grant of 100,000 shares, the resulting income is $5,000. Assuming the employee has an effective federal income tax rate of 30 percent, he will pay a total of $1,500 of U.S. federal income tax as a result of the grant and Section 83(b) election. Under Section 83(a), where no Section 83(b) election is made, the employee had income of $200,000 and total income tax payments of $60,000 over the four-year vesting period.

Section 83(b) allows a service provider to elect to accelerate the taxable event to the grant date rather than the vesting date. Without exception, the election must be made within 30 days of the grant date. The effect of the election under Section 83(b) is the service provider will receive, and be taxed on, compensation equal to the amount by which the fair market value of the restricted property as of the grant date exceeds the amount paid for such property, if any, by the service provider. For example, if the service provider paid fair market value for the restricted property and made a valid election under Section 83(b), he would neither receive nor be taxed on compensation as of the grant date. Alternatively, if the service provider paid a discounted price for the restricted property, or received it free of cost, then the difference between the fair market value of such property and the price paid by the service provider for such property will be taxed as compensation to the service provider as of the grant date.

When a service provider makes a Section 83(b) election, he is treated as the owner of the restricted property for U.S. federal income tax purposes. The significance is the vesting of such property will not be a taxable event, and when the property is disposed of, any appreciation since the grant date will generally be treated as capital gain rather than ordinary income. The potential value of a Section 83(b) election is attributable to the difference between the tax rates imposed on ordinary income (i.e., top marginal federal rate of 39.6%) and long-term capital gain (i.e., top federal rate of 20% plus 3.8% net investment income tax). If the service provider makes a Section 83(b) election and holds the restricted property for at least one year from the date of the grant, he will generally be taxed at the preferential long-term capital gain rate when he subsequently disposes of the property. Property held less than one year since the transfer will be short-term capital gain taxed, which will incur tax at the service provider’s marginal ordinary income rate.

The Section 83(b) election is made under Treasury Regulation Section 1.83-2, and must be sent to the IRS and include basic identifying information, as well as a simple description of the property to which the election applies. The IRS offered sample election language in Revenue Procedure 2012-29. The election must be filed within 30 days after transfer and there is no flexibility on the deadline.

The primary disadvantage of the election is its irrevocability. If the service provider makes the election and pays tax on the restricted property, then later must forfeit the property or the property drops in value, there is no way to undo the Section 83(b) election or to get a tax refund. The service provider may receive a capital loss in the year of the forfeiture, but that loss may or may not be usable by the taxpayer. In situations where the initial value of the Section 83 property is low or zero, the potential downside of an election is limited. Conversely, in situations where the initial value of the Section 83 property is substantial – like stock of established companies – the potential downside of the election may be significant.

A Section 83(b) election is particularly valuable to employees, founders and vendors of startups. New ventures typically have low-value equity, especially in companies that are pre-revenue or otherwise not profitable. A Section 83(b) election for unvested stock in such a startup is generally very low cost (beyond the filing cost to make the election) and may not trigger any tax due. Converting the appreciation of that stock to capital gains and starting the holding period for the shares can result in significant tax savings to founders and employees. The biggest hurdle is the strict 30-day deadline for making the election, a restriction that all startup founders and employees must remember. The biggest risk is that the election, once made, generally cannot be undone if the property later fails to vest or drops in value.