This article addresses the issue so many small businesses face. How do we get equity positions to our founders and employees.
General Rule. IRC §83(a) provides the general rule for the tax treatment of employees who receive company equity interests as compensation for services. Consequently, this section applies to (1) property (generally stock or some other form of equity) (2) transferred (issued to the employee) (3) in connection with the performance of services by the employee in the future in exchange for the property. The interests received must be “transferable.”
The general rule is that gain is recognized by you on the excess of the fair market value of the equity received over the amount paid on receipt of the property. If there is a substantial risk of forfeiture of the property, however, you delay the tax event until the lapse of the restriction.
Property is “transferable” when it can be sold, assigned, or pledged to a third party. Treasury Regulation § 1.83-3(d). Transferred property is subject to a “substantial risk of forfeiture” and not transferable if your rights in the property are conditioned on the future performance or nonperformance of substantial services. Treasury Regulation § 1.83-3(c). A taxpayer becomes fully vested in the granted shares after the restrictions lapse. See Treasury Regulation § 1.83-3(b).
The regulations under IRC §83(a) emphasize the IRS’ long-held position that a provision or clause that may result in the forfeiture of your equity must be sufficiently likely to actually result in forfeiture in order to prevent taxation. This risk exists only if your rights are conditioned upon the future performance (or refraining from performance) of substantial services and if your possibility of forfeiture is substantial. Thus, if you received equity subject to vesting, a substantial risk of forfeiture would exist and there would be no taxation until the risk lapsed.
Exception to General Rule. IRC §83(b) offers an alternative to the general rule and lets the employee choose to be taxed in the year in which the property is received. Although this generates tax liability up front, it is beneficial in that it allows any tax on the appreciation of the property between the time of receipt and the time of vesting to be deferred until the taxpayer sells the property. Additionally, when the taxpayer eventually sells the property, any gain is taxed at the lower capital gains rates rather than as ordinary income. The employee, however, takes the risk of loss on the investment if things do not pan out.
Illustration. Let’s assume that on January 1, 20190, a company issued an employee 100 shares of its stock valued at $1,000. The stock was subject to vesting and the employee would have forfeited the stock if he or she quit before January 1, 2021. The employee quit on January 1, 2021, the same day the shares vested and the risk of forfeiture lapsed. The shares were then worth $2,000. The shares then then sold on January 1, 2022.
Taxes under IRC §83(a). The employee would not have been taxed at receipt of the shares in 2019 because the property had not yet vested due to there being a substantial risk of forfeiture. The employee would have been taxed in 2021, the year the risk lapsed because the shares then became transferable and would have resulted in $2,000 of ordinary income and the incurrence of all applicable payroll taxes. If the employee subsequently sold the stock for $10,000, he would have a basis of $2,000 and $8,000 in long-term capital gains.
Taxes under IRC §83(b). If the employee had filed an 83(b) election by January 31, 2019, he would have been taxed in 2019 on $1,000 at ordinary income tax rates and would have incurred payroll taxes on that amount. There would have no taxes in 2021 on vesting. If the stock subsequently sold for $10,000, there would be a $1,000 basis and $9,000 in long-term capital gains. The risk in making an 83(b) election under these circumstances is that the employee would pay ordinary income and payroll taxes in 2019 on stock that could become worthless.
Choice. Your choice in grants subject to vesting is to recognize the tax at ordinary rates in (i) the year of receipt and risk subsequent losses under IRC §83(a); or (ii) recognize the tax at vesting under IRC §83(b).
IRS Filing. IRC §83(b)(2) requires an election to be made under IRC §83(b) and filed with the IRS no later than 30 days after the date that the property is transferred to the service provider. The filing must be on paper.
In short, this procedure applies to taxpayers who receive substantially nonvested property in connection with the performances of services and which to make the IRC §83(b) election.