By Gary Hewamadduma ACMA, CPA, CGMA, MBA, B.Sc.(Hons) in Computer Engineering
You are a founder of a company or a member of the founding team of employees. Company has a lot of promise, but funds raised are for purposes other than for C-suite compensation. So, the Board decides to compensate you with equity stock. Once you get the stock, one of 3 things (in general) can happen;
- You work towards the success of the company. Everyone including you, gains as the price of the stock increases as the value of the company rises.
- Company is in the right direction but halfway through, you lose interest (internal conflicts, better opportunities or whatever the case may be) and decide to leave the company.
- You take the investor money and do not perform well for the long-run, but use it as a way to make payroll for yourself within Board approved limits (essentially, creating a ‘job’ for yourself).
From an investor’s perspective, only the scenario 1 is desired and scenario 2 and 3 must be avoided (or discouraged). So, how is it done? Simply make the issued stock ‘restricted’. Stock is issued but it vests over a period of time, say over 4 years. That is a clear-cut way to ensure that you (the stock holder) are happy and encouraged to achieve company goals while protecting their investment.
Let’s take an example. Let’s say that you receive 1M shares at a par value of $0.0001 at the inception of the company. You pay the company 1M x $0.0001 = $100. Let’s also assume, the value per share at the time of stock grant is $0.001. So, the total value of what you receive is 1M x $0.001 = $1000 at this time. Let’s also assume the 1M shares are going to vest at 1-year cliffs over 4 years, 250K shares per year.
Let’s assume the company grows in value and valuation of shares proceeds as below:
(Bit of an extreme example to show the impact)
End of year 1: $10 per share
End of year 2: $20 per share
End of year 3: $30 per share
End of Year 4: $40 per share
What is the tax implication if you take no special action at the time of receiving the stock grant?
Even though you have not sold the stock, IRS considers the vesting of stock as receiving the assumed value. So, you are liable to pay the tax for receiving that value.
Year 1:
Base = 250,000 x $0.0001 = $25
Value = 250,000 x $10 = $2,500,000
Taxable Income = $2,500,000 – $25 = $2,499,975
Year 2:
Base = 250,000 x $0.0001 = $25
Value = 250,000 x $20 = $5,000,000
Taxable Income = $5,000,000 – $25 = $4,999,975
Year 3:
Base = 250,000 x $0.0001 = $25
Value = 250,000 x $30 = $7,500,000
Taxable Income = $7,500,000 – $25 = $7,499,975
Year 4:
Base = 250,000 x $0.0001 = $25
Value = 250,000 x $40 = $10,000,000
Taxable Income = $10,000,000 – $25 = $9,999,975
In addition, at some point when you actually sell the stock, you will get stuck with capital gains taxes.
What if you pay all that and in the 5th year, the company goes bust? (Or share value is reduced significantly?). All that tax money you paid would be for nothing. Scary situation right?
This is where 83(b) Election comes in handy
The 83(b) election is a provision under the Internal Revenue Code that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.
(You need to file the 83(b) within 30 days of the stock grant. In addition to IRS filing, the recipient of the equity must also submit a copy of the completed election form to the company and include a copy with your annual tax return.)
So, what is the gain of doing the 83(b) Election?
You consider the stock grant as fully vested, just for tax purposes. That would mean, at the point of grant,
Base (what you paid the company) = 1,000,000 x $0.0001 = $100
Value = 1,000,000 x $0.001 = $1000
Gain = $1000 – $100 = $900
You pay applicable income tax for that $900 and you are done. (You will still pay capital gains tax at the point of sale, but no taxes at annual vesting cliffs.)
You can see the huge tax saving in this particular example. Even if the figures are much smaller, it can still amount to a significant saving for the stock recipient.
Any flipsides?
If the equity value falls over time after you file 83(b) and pay taxes, then you have overpaid in taxes for shares with a lesser value. However, the IRS does not allow an overpayment claim of taxes under the 83(b) election. That was what happened right around 2000-2001 with “Dot-com-Bust”. People who received large amounts of restricted stock had already paid huge tax bills based on share valuations that became worthless in the end.
Another possible scenario is; if the stock holder decides to leave the company before it is full vested, you have paid taxes for the full share amount which in reality has not been received. (This is a minor issue if the value of the shares has gone up, in most practical situations.)
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