Many start-up companies reward their employees with restricted stock subject to time-based (or performance-based) vesting restrictions. What we sometimes find is that the start-up company and the employee do not fully appreciate the tax implications of a restricted stock award and the potential benefits of a timely filed Section 83(b) election.
Section 83 of the Code generally provides that restricted stock becomes taxable to the employee as the stock vests. Accordingly, on each vesting date, the employee will recognize ordinary taxable income in an amount equal to the fair market value of the stock, less any amount the employee paid for the stock. In the context of a private company with illiquid stock, this often creates a tax problem for the employee because the employee cannot sell stock to pay taxes and instead must come out of pocket with cash to pay his or her tax bill.
In the right circumstance, a Section 83(b) election may mitigate the tax consequence described above. If the employee files a timely Section 83(b) election, the employee is taxed on the fair market value of the stock at the time the stock is granted rather than as the stock vests. By making the Section 83(b) election, the employee also starts the clock on the capital gains holding period. By making the election, the employee is taking a risk that the value of the stock will appreciate and that he or she will satisfy the applicable vesting condition.
The power of the 83(b) election for a start-up company is best illustrated by the following example:
Assume that a company awards an employee 20,000 shares of restricted stock. The restricted stock agreement provides that all 20,000 restricted shares will become vested shares on the fifth anniversary of the date of grant. On the date of grant the fair market value of the stock is $1.00 per share. On the fifth anniversary of the date of grant the stock has appreciated in value and is worth $10.00 per share. Assume the employee remains employed through the fifth anniversary of the date of grant.
- Tax Impact for employee without a Section 83(b) election:
- On the fifth anniversary of the grant date, the restricted stock fully vests and the employee recognizes ordinary taxable income equal to $200,000 (20,000*$10.00). Assuming an effective tax rate of 30%, this would result in a tax liability of $60,000 ($200,000*30%).
- The holding period for capital gains will not begin to run until the fifth anniversary of the date of grant.
- Tax Impact for employee with a timely filed Section 83(b) election:
- The employee recognizes ordinary taxable income on the date of grant equal to $20,000 (20,000 *$1.00). Assuming the same effective tax rate of 30%, this would result in a tax liability of $6,000 ($20,000*30%).
- The holding period for capital gains will begin to run on the date of grant.