A CREDO TAX PLANNING STRATEGY SOLUTION
SECTION 83(b) ELECTION: What Company Founders, Employees, and Other Service Providers Need to Know
While restricted stock units and stock options are a fantastic way to accumulate wealth over time, there’s a possibility that you will end up having a huge tax bill when stocks are vested because stock compensation is taxable and stock prices have a tendency to appreciate fast. And so startup founders and stock option holders should care about Section 83(b) election as this could help them minimize their tax outlay.
WHAT IS SECTION 83(b) ELECTION?
Making an 83(b) election means requesting from the IRS that they let you be taxed on your equity (like shares of restricted stock) on the date the equity was granted (and not later upon vesting). Through this, your ordinary income tax is being accelerated. Take note though that this is only applicable for stock that is subject to vesting (because grants of fully vested stock will be taxed at the time of the grant).
Section 83(b) election allows startup company founders and stock option holders (who are getting restricted stock) to save a significant amount of taxes. This is because tax is dependent on the property’s fair market value at the time of granting and not on the fair market value that it vests. Section 83(b) election should be filed within 30 days after receiving the restricted stock to prevent any tax problems in the future (to avoid the risk of forfeiture).
Filing an 83(b) election on time allows you to pay income taxes earlier (way before the appreciation in value of your company shares). When the time comes that you are able to sell shares for a gain, you would only need to pay for capital gains taxes (and not the ordinary income taxes which are of a higher rate). When you hold shares for more than a year before selling, it paves way for more favorable long-term capital gains taxes. Through filing an 83(b), you are able to start the holding period clock in advance (which is right after the grant date) so the accumulated capital gains would be eligible for the lower capital gains tax rate.
WHO CAN FILE AN 83(b) ELECTION?
STARTUP FOUNDERS
There are companies (most especially startup ventures) who include a considerable amount of restricted stock to compensate the owners or founders. Restricted stocks are compare shares that are subject to specific requirements like vesting and / or forfeiture (leaving the company entails losing your shares). Employees who play key roles in the company may be granted a attractive quantity of restricted shares that could potentially increase in value from granting to investing. Through 83(b) election, these employees are given the chance to save by transferring their tax treatment from ordinary income taxes to capital gains taxes.
STOCK OPTION HOLDERS
When you are exercise your stock options prior to investing, you can elect to pay your taxes for it on the grant date (you should file for 83(b) election within 30 days of exercise). Doing so could you potentially lessen any future tax liability in case the share price of the company takes off.
THE TAX STRATEGY
When is filing a 83(b) election a smart move?
Filing a Section 83(b) election is ideal if your stock is subject to a vesting schedule and you anticipate the stock price to appraise its value significantly over the course of the vesting period.
Here’s an example:
Assuming that you are granted 70,000 shares and it is worth $1 each with all stocks subject to a 3-year vest (for instance, these stocks fully vest in year 3 but you won’t have any vesting until then). Should you elect to the 83(b) and choose to pay the tax right after the stocks have been granted, you would only need to pay the ordinary income tax on $70,000.
Using the same scenario, if you failed to file an 83(b) (and the holding period of three years has passed with your stocks fully vested and owned) and the stocks appreciated its value (say, the share is now worth $5 each), this means that the full amount of $350,000 (vested stock in year 3) would be subject to tax. Imagine the consequences of not filing an 83(b) election right after the stocks were granted to you?
As nobody knows your financial situation would be in the future, it is ideal that you pay the taxes on your shares at the time of granting (while you still have a clear outlook of your financial state). It is also ideal if you synchronize your stock payment and 83(b) with your tax plan. If for instance you made a large charitable contribution on the early part of the year and you eventually acquired restricted stocks, the combination of both and of the other tax deductions would help in offsetting the tax that you are obliged to pay on your stock. Thus, filing for 83(b) is a smart move.
When is it not ideal to file for 83(b) election?
Despite the promising tax savings that it offers, there are instances when skipping the 83(b) election is ideal. Here are some scenarios that prove this:
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Your shares are expected to decrease in value within the holding period
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The company just went public and you joined at a later stage
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Despite the IPO going well, there are times wherein stocks are buoyed merely by optimism often linked with public offerings. You believe that the market will correct soon and that there’s a possibility for a price drop.
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You don’t intend to meet the vestment terms (i.e. you don’t have plans of staying in the company longer) so there’s no point of paying the tax on the stocks right after you’ve been granted.
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The fair market value of your restricted stock is too high and it will put you into a higher tax bracket (your effective tax bracket rate would be higher than you anticipated on the 1st year). In this case, any tax savings in the future years would not possibly offset the higher taxes you would be paying on year 1.
Take note that depending on the circumstances, it’s imperative that you understand your options when deciding whether or not to opt for 83(b) election. As there are no guarantees, choosing when to pay taxes on your shares have inherent risks that the stock price would be the reverse of what you are expecting.
HOW TO FIX A MISSED SECTION 83(b) ELECTION
Section 83(b) election has to be filed within 30 days of receiving the unvested stock. And it’s non-negotiable. So in case you missed it, how can you mix it and what are your options?
Here are some alternative fixes that company owners can do to prevent future tax at vesting of the stock. Take note that these options are not fixes to any underwithholding that may have already transpired if the date of vesting has come and gone.
Surrendering the Grant, then Regrant It (in an alternative equity form)
The founder can surrender the stock and replace it by granting an alternate form of equity which could be stock options or stock appreciation rights. This is an option provided that the awards are not early-exercisable. The new grant could also be a profits interest if the company is taxed as a partnership.
However, since this fix is clearly a business change deal, it would require new terms that should be negotiated by both parties. This means that if the new award were an incentive stock option, there’s a possibility that it would result to the similar tax treatment (provided that the founder is not in substitute minimum tax land at the time the ISO is exercised and the sale of shares is of eligible nature. In the same way, a profits interest with a catch-up could end up in a comparable treatment to a capital interest grant.
Expediting the Vesting or Pulling Out the Right to Re-purchase at Cost
With Section 83(b) election, stocks are made taxable at grant instead of when vested. But can a company expedite the vesting? The answer is yes, for as long as the parties are not surreptitiously planning to re-subject it to vesting (given that an investor enters the scene in the future and subjected it to vesting).
A more distinct version of this idea is to pull out the right to re-purchase at cost. Normally, a restricted stock agreement will either provide that:
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Forfeiture of unvested shares upon termination of service, or
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Re-purchase of unvested shares for a specific period of time after an expiration of service at the price it was originally purchased (or whichever is lower between the original purchase price and the lower price of the fair market value)
Based on the tax rules, to expedite the tax, there’s no need to totally get rid of the vesting concept. Instead, the award can be amended so that the unvested shares can be re-purchased by the company at fair market value on the date of the re-purchase. Tax considerations would be:
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Prevents tax on the future vesting of the stock (just like all other fixes).
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But this amendment results to having the taxable compensation income to be recognized instantly by the stockholder on an amount that is equivalent to the stock’s value (on the amendment date) less the original purchase price (if any). Simply put, an increase in the value from the date of grant will result to a higher tax than what could have been with the Section 83(b) election.
This fix is not commonly used by companies as there’s a reason why the stock was initially subjected to vesting and the parties are more often than not eager about removing it.
Making the Stock Transferable
A number of tax practitioners think that by making unvested stock transferrable to a small group of permitted transferees (like the large shareholders), you can accelerate the tax to today to prevent tax at vesting. Under Section 83, taxation’s default at vesting is allowed only if the restricted stock is subject to both a considerable risk of forfeiture and a restriction of transferability. It must be noted though that the stock would become fully-vested only if it is transferred (which can be done in any of the restricted stock agreement or in a side-agreement).
There are times that the parties desire to add language obliging the stockholder to expel any profits generated in such a transfer or sale. But it is always safer to permit the stockholder to retain any gain.
Most parties are likely to choose this option since it entails very little change to business deal. The service provider keeps the restricted stock grant subject to original vesting schedule. Though a service provider would most likely not exploit the new transferability, in theory, he could and if he chose to, the transfer would result to the full vesting of the stock.
Take note also that this option causes the tax on the current value of the unvested stock less purchase price (if there’s any).
CONSULT WITH CREDO
Our team’s breadth and depth of experience in assisting clients in their tax planning and strategy enable us to help you weigh your options when it comes to deciding if your should opt for 83(b) election or not. Talk to us now and let’s discuss if this special stock exception is ideal for you.
