The Internal Revenue Service (IRS) requires that an individual report any income recognized in a particular year. Included in the definition of income is stock received as compensation for services rendered to a company. Pursuant to Internal Revenue Code (IRC) section 83(a), the individual receiving the stock will report the value of the stock as compensation or equity grant when they become owner of the stock.
Stock grants are contract that contain numerous provisions. In most cases, the employee receiving the stock as compensation may not fully own the stock grant to them. That is, a stock grant to employees is often subject to restrictions and a vesting schedule. This means that the stock cannot be immediately sold. If it cannot be immediately sold, it shareholder does not have the ability of cashing out stock. Also, the shareholder does not become full owner of the stock until it vests in them. The vested shares will generally vest along a timeline (generally over 4 years) or upon the company meeting certain performance metrics. Also, often times, none of the stock will vest until a specified period of time has passed. Once that period has passed (generally 12 months), a specific percentage of the stock will vest (generally 25% of stock granted). This is known as a “cliff”. The purpose of this arrangement is to make certain an employee stays with the company and remains loyal after receipt of the stock grant. It would not be good for the company for the employee to immediately leave the company holding the stock. This waiting period is known as the vesting schedule.
Acceleration of Stock Vesting
The stock grant will generally include an acceleration clause. This acceleration clause makes it so all or some percentage of the stock vests immediately upon the occurrence of certain events. The most common forms of acceleration clauses are “single-trigger” acceleration and “double-trigger” acceleration. In single trigger acceleration, if the company is sold, the shares previously granted to the employee vest immediately. In double trigger acceleration, the shares will immediately vest if the company is sold, and the employee is fired without case, or the employee is forced to quit because of unreasonable requirements by the purchaser of the company. An acceleration clause is very common with a stock grant.
Tax Consequences of Section 83(a)
The effect of the restrictions and vesting schedule is to make it so the employee does not immediately recognize the stock grant as income — because they are not full owners of the stock. That is, the stock grant is still subject to a “substantial risk of forfeiture”. Because the stock grant will not completely vest until some time in the future, section 83(a) says that the employee does not currently recognize it as income. This is a real problem for the employee of a startup company who receives an equity grant as stock. The employee assumes that the value of the stock income awarded is going to rise. In such a case, an employee who completely owns the stock would experience capital gains on stock value. The capital gains on stock are not recognized as income until the stock is later sold. This allows for tax deferment (until sale). If the stock is subject to vesting, the employee is required to recognize the value of the income at the time that it vests according to the vesting schedule. This means that, if the stock has risen in value since the time of stock grant, the employee must recognize the higher value as income at the time of stock vesting. This is not favorable, as the amount of taxes on income is generally higher than the taxes on capital gains. Further, this option does not allow for deferral of taxation until the stock is sold.
Benefits of Section 83(b)
The savior for the employee is IRC section 83(b). This provision allows the employee to elect to recognize the full value of the granted shares immediately. That is, the employee does not have to wait until the shares vest to recognize the value of the shares as income. The value of this option regards the amount of income stock recognized. The employee recognizes the income stock when it is lower in value. When it rises in value in the future, it is taxed at a capital gains rate and it is not taxable until the income stock is sold.
Filing an 83(b) Election
To file the form 83(b) election, the shareholder must send the prescribed election form to the IRS requesting immediate recognition of the shares as income. The letter must be mailed within 30 days of the stock grant. Failure to make the election forfeits the election. The state department of revenue may also require that a copy of the form 83(b) election be attached to the recipients state income tax return.
Generally, an employee is better off filing form 83(b) election. The only time that an employee would think twice about the election is when the value of the shares upon receipt is excessive. Say the employee receives 100,000 in shares that are not able to be sold. She may not have the money to pay taxes on the shares immediately. Also, if the company eventually loses value, the employee may be advantaged to have deferred revenue recognition of income until the shares fully vest.
LawTrades Can Help
Granting stock to employees can be a complicated process. The process is made more complicated with the stock is subject to restrictions and vesting schedules. Do not risk making an error that costs you or shareholders extensive value or deferred revenue recognition. The legal experts at LawTrades are experts in stock grants or equity grants. They can assist you every step of the way.