Many employee stock options as a form of compensation. Often the employee does not receive immediate ownership of the stock; rather, ownership of the stock vests in the employee at a specific time in the future. The employee may have to satisfy certain conditions or milestones for the stock to vest. This might include working for the company for a specific period or meeting certain performance criteria. The typical vesting period for a startup company stock is four years.
Taxation of Stock Awards
An employee is not deemed to have received compensation for tax purposes until the time that ownership of stock vests. Vesting occurs when conditions are satisfied or, if earlier, at the time the employee can transfer the stock to a third party with the third party not being bound by any risk of forfeiture. This is not always a preferable outcome for the employee. If the stock rises in value between the time of the stock award and the time that it vests, the employee will ultimately be subject to income taxes on a larger amount of compensation. This problem is made worse when there are restrictions on selling stock options. So, the employee may not be able to sell the restricted stock to cover the tax obligations at the time the stock vests. As such, employees would often prefer to recognize the stock as income at the time the stock is awarded. Paying income taxes on the stock at the earlier time and lower valuation results in lower taxes.
Generally, the employee would pay income tax on the stock at the time it is awarded. If the stock increases in value, the employee will not be subject to taxation on that increase in value until she sells the stock. At that time, she would be subject to capital gains tax on the amount that the stock increased in value. The capital gains rate is generally lower than the personal income tax rate, and such compensation is generally not subject to Medicare and Social Security taxes.
Section 83(b) Election
Section 83(b) of the Internal Revenue Code (IRC) allows the employee to elect to recognize the stock award as income at the time of receipt of the stock. To take advantage of this provision, the employee must file a Section 83(b) election with the Internal Revenue Service (IRS) within 30 days of receiving the stock. The 30-day period cannot be extended.
If an employee finds herself in the unfortunate position of failing to make the 83(b) election, there are a few options she can attempt to remedy the failure.
- Quit Your Job – One option is to quit your job and stop the stock from vesting. You can arrange for the company to rehire you under conditions that allow you take advantage of available tax deferment. Of course, there is always a risk in this situation that it looks like fraud to the IRS or that the company later refuses to rehire you.
- Immediate Vesting – Another option is to have the company amend the stock issuance to make the shares vest immediately. This would cause tax liability on the current fair market value of the shares. Of course, the company may not be willing to immediately vest the shares. This would defeat the purpose of the shares being subject to vesting in the first place.
- Company Repurchase – Another option is to transfer the unvested shares back to the company. The company could then re-issue new shares to you. The only downside is that, if you make the 83(b) election, you will be taxed at the fair market value of the shares at the time that the new shares are issued. Also, there is a possibility that the IRS will not recognize the re-issuance.
- Change Company Repurchase Value – Another option is to amend the stock grant to require any repurchase of the unvested stock by the company to be at fair market value, rather than the value at the time of issuance. If the company is required to repurchase any unvested shares if the employee leaves or a condition for vesting is not met, the IRS treats it as if there is no “risk of forfeiture”. Therefore, the stock grant is immediately taxable as compensation. Again, the company may not be willing to accept these conditions.
- Corporate Governance Defect – Another option is to argue that the stock grant was not legally effectuated. This could be the case if the board fails to follow governance procedures in issuing the stock. This would allow the board to reissue the stock using appropriate procedures. Such event would allow for the 30-day clock to start anew.
- Third-Party Transfer – Another option is to verify the conditions restricting transfer of the stock. Some employee stock restrictions provide that the employee can transfer shares to a third party even if the shares are not vested, but that the employee (and not the employee’s transferee) will be obligated to reimburse the employer if the employee fails to satisfy the vesting conditions. If these conditions are not present, it may be possible to amend the stock grant to allow for such a transfer. If the stock meets these characteristics, the employee may be able to arrange a transfer or sale of the stock to allow immediate recognition as income. There is also an argument that the shares are no longer subject forfeiture if these conditions are present, even if the employee does not actually transfer the shares. The stock would then be subject to tax at the value of the shares at the date of amendment to allow transfer.
Note that you cannot legally backdate or alter old paperwork. This would be illegal. Taking steps to amend the characteristics of the stock grant may be permissible under state law.
LawTrades Can Help
Dealing with stock grants is a complicated matter. It can involve issues of corporate governance and taxation. Don’t go it alone. The legal professionals at LawTrades can assist you.