A common form of compensation for management and executive level employees is a grant of equity in the employer company, or the option to purchase such equity at a reduced price. Compensation in the form of equity can be a big incentive for employees to join a new company, particularly a startup, or stay at a company where they are currently working. Equity can also give the employee some skin in the game usually intended to serve as extra motivation to grow the company. But how is equity compensation taxed?1
The tax consequences of equity compensation are often an afterthought in negotiations, but a well advised employee will take into account the tax effects of such arrangements as part of the negotiation process. The tax consequences are often complex and may result in the employee being placed in a difficult situation in terms of liquidity to pay taxes, among other potential adverse issues that may arise.
General Tax Consequences of Equity Compensation
A complete discussion of the taxation of equity compensation is beyond the scope of this article, but in general, equity compensation is taxable at the time the equity is received.2 However, where the equity has restrictions such that there is a “substantial risk of forfeiture”, the equity is not taxable as compensation to the recipient until the equity no longer has a “substantial risk of forfeiture.”3 This type of equity arrangement is typically referred to as restricted stock4, or unvested stock (restricted and vested, and unrestricted and unvested, are used interchangeably herein), and is not taxable to the employee until the restrictions are lifted or the stock has vested. While this article discusses equity compensation in the form of stock, the same concepts apply to equity compensation in other types of entities such as a partnership or a limited liability company. In determining the amount of the equity compensation, the fair market value of the stock at the time of vesting is used, less anything paid by the employee for the stock.5 So if the stock was worth $100 at the time it was issued as unvested stock, but worth $200 at the time of vesting, the employee would have $200 of taxable income at the time of vesting assuming the taxpayer did not pay for the stock.
In a typical arrangement, the employee will be granted equity as soon as the compensation arrangement is entered into, but such equity will be unvested and subject to [a substantial risk of] forfeiture should the employee leave, be fired, or due to any other number of contingencies which may be built into the employment agreement. The shares typically vest over a period of time, and often in increments. For example, an employee may be granted 10% equity in a company, with 2.5% vesting every year. Thus at the end of the 4 year term, the full 10% would be fully vested. Under this scenario, the employee would be taxable on the value of 2.5% of the company every year, and the fair market value would have to be redetermined each of the 4 years to determine the amount of taxable income to the employee each year. Additionally, the taxpayer’s holding period for each 2.5% of the stock starts upon vesting, so the taxpayer ends up with 10% equity but 4 separate holding periods for purposes of long-term capital gain treatment. Alternatively, restricted shares may be subject to “cliff vesting” where all shares are unvested until the end of a term, upon which all shares vest at once.
On the employer side, the employer receives a deduction equal to the amount of taxable income of the employee, and the timing of the deduction must match the timing of the employee’s income inclusion, whether that be upon vesting discussed above, or upon grant due to the §83(b) election discussed below.6
Electing to be Taxed When the Equity is Granted: Section 83(b)
- 83(b) provides the taxpayer with an option to elect to have restricted stock taxed at the time it is granted rather than at the time of vesting.7The election must be made within 30 days of the equity being issued.8 There are no exceptions as the 30 day deadline is statutory rather than regulatory, and accordingly, the IRS has no discretion or authority to grant extensions.9 If an employee misses the 30 day deadline, the §83(b) election is no longer available.
Going back to the example above where the employee was granted 10% equity in a company, with 2.5% vesting every year, if the employee makes a valid §83(b) election within 30 days of the original grant, the employee will be taxed on the fair market value of the 10% equity on the date the equity was granted even though the equity is restricted. If the value of the 10% equity is $100 at the date of issuance, the employee has $100 of taxable income on the date of issuance regardless of the value of the stock when it vests in the future. The §83(b) election does not change the mechanics of the stock vesting, and the stock remains subject to the vesting schedule (including forfeiture) of the equity compensation arrangement. The 83(b) election merely changes the tax consequences, both in value and timing. Additionally, making the 83(b) election starts the taxpayer’s holding period for purposes of long-term capital gain treatment rather than waiting until vesting for such holding period to start.
The Pros and Cons of Making the Section 83(b) Election
As with most tax elections, there are both pros and cons to consider when determining whether to make the §83(b) election. The two primary pros are:
- Setting the value of the equity and thus the taxable income, as of the date it is granted, and avoiding ordinary income on appreciation during vesting period: The §83(b) election sets the amount of taxable income as the fair market value of the equity at the time it is granted allowing the taxpayers to have a lower value included in taxable income should the company appreciate over time during the vesting period. Back to our example above, the taxpayer had $100 of taxable income after making the election. If we assume the company were to grow at 50% per year during the vesting period, the taxpayer would have taxable income as follows had taxpayer not made the §83(b) election: End of Year 1, $37.50; End of Year 2, $56.25; End of Year 3, $84.37; and End of Year 4, $126.56, for a total of $304.68. Should the taxpayer sell in the future, all of that income would ultimately be recognized anyway in the form of gain but the taxpayer would have converted at least $204.68 from ordinary income to long term capital gain taxed at a significantly lower rate, and potentially more should a sale occur within 1 year of the final 2.5% vesting. Additionally, the taxpayer would have deferred taxes on at least $204.68 of gain until a future disposition or other taxable event. Of course, as discussed in the cons section below, there is always the potential that the value of the company declines during the period between the equity grant to the time of vesting.
- Starting the holding period for purposes of long-term capital gain treatment: The §83(b) election starts the taxpayer’s holding period as of the date the stock was granted. As discussed above, this can result in converting what would otherwise be ordinary income or short-term capital gain taxed as ordinary income into long term capital gain taxed a significantly lower rate.
A few of the cons are:
- Liquidity to pay the tax: While this is always an issue with equity compensation as the taxpayer has taxable income but no cash with which to pay the resulting tax, it can be an increased burden when making the §83(b) election. In our example, the taxpayer would have to pay tax on the full 10% upon granting rather than spreading out the tax liability over the four year vesting period, all values being equal. Of course, if the stock was subject to cliff vesting all at once, the tax liability would not be spread out but the employee would have time to plan for the tax liability that would be owed in the future. Since the stock is unvested, the taxpayer does not have the option of selling a portion of the stock to generate the funds needed to the pay the tax. Further,often these arrangements are used in closely held companies so selling the stock may not be a viable option in the first place. There are plenty of creative ways to work around this problem but it is nevertheless an issue that has to be addressed in equity compensation planning, and particularly when considering whether to make the §83(b) election.
- Risk of equity not vesting: As discussed above, making the §83(b) election only changes the tax consequences, but has no effect on the actual vesting of the equity. When making the §83(b) election, the employee runs the risk of something happening prior to the stock vesting and thus the employee could be left in position where they have paid on tax on the stock but then have to forfeit the stock. There is no corresponding ordinary income offset or deduction under this scenario although the taxpayer would have a capital loss for the value of the stock included in income. The taxpayer is left in the unenviable position of having ordinary income and a corresponding capital loss, the opposite of what a tax planner typically tries to achieve.
- Risk that the value of the company will decline during the vesting period: Should the value of the company decline during the vesting period, a taxpayer who makes the §83(b) could end up paying more in tax than they would have had they not made the election and just had the equity be taxable when it vested. Obviously, a taxpayer hopes this would never be the case but it is also a possibility to be considered during the analysis of whether making the §83(b) election is the right call.
As discussed above and as illustrated in the table below, making the §83(b) election can be a powerful tool to reduce overall taxation on the grant of equity compensation, but the decision of whether to make the election should not be taken lightly as there are risks and downsides associated with the election. There is no right or wrong answer as every situation is unique and presents its own issues. Taxpayers should be aware of the tax consequences of equity compensation and seek out the help of a competent advisors during negotiations for the same. Armed with an understanding of the tax consequences, issues, and options such as the §83(b) election, taxpayers entering into an equity compensation arrangement can places themselves in the position to make the best decision for their particular set of facts and circumstances.
- Note this article discusses only federal income tax and does not discuss state income tax. Additionally, this article does not discuss federal income tax withholding issues or employment taxes as they can be extremely complex. Further, non-qualified deferred compensation plans under §409A and profits interests in partnerships are not discussed herein. A full discussion of such issues is beyond the scope of this article.
- IRC § 83(a).
- Restricted stock should not be confused with what is commonly referred to was restricted stock units. Restricted stock is issued and may have voting right immediately whereas restricted stock units are merely an unguaranteed promise to issue stock at a later date. Since restricted stock units are not actually issued until a future date, they are not eligible for the §83(b) election discussed in this article.
- IRC § 83(a).
- IRC § 83(h).
- IRC § 83(b)(1).
- IRC § 83(b)(2).
- Welsh v. U.S., 52 AFTR 2d 83-5113 (Cl. Ct. 1983).