Introduction:
Stock options or stock grants have long been a coveted part of the compensation package offered to employees in startup companies, especially in the high-tech area. Indeed, millionaires have been made by these types of compensation and it is a common dream of employees in high tech to be in on the ground floor of a startup and benefit from this type of offer.
Essentially, the option is the right to purchase stock at the current price in the future, regardless of how the value increases over time. If the value does not go up, you do not exercise the option. Some plans simply grant the stock over time without requiring out of pocket purchasing but vest that right to own the stock over time.
Often certain criteria are imposed before the option can be exercised, such as continued employment or performance criteria. Often the stock purchased cannot be sold for a specified period of time. Nevertheless, these are a tremendous benefit if the company appreciates significantly after the option or grant is made.
In reality, of course, most startups fail, and the benefit is of little or no value. It is the possibility of the upside, however, that draws talent to the startup companies and there is little as exciting as working and knowing that you may be the beneficiary of a tremendous appreciation of the ownership value.
Most such options give the employee the right to exercise the option for a relatively low “startup” value and enjoy the appreciation. That right may extend for years with the original option price remaining in place so long as employment or some other criteria is met. In short, one has the right but not the obligation to purchase the stock for the initial pricing and that appreciation can be yours if you exercise the option. Often options are given in stages, with the right “vesting” in whole or part and becoming possible to exercise only over time as the employee continues to work for the company. Each option plan is different, and reference should be made to the plan itself. (Note this is not the same as granting actual stock to the employee, which is a taxable event when paid, as any other compensation.)
A key issue that an employee receiving such an option must consider is the taxation of such an option and that is the subject of this article. Remember: if you want this election, you have a thirty-day time limit to so elect.
The Basic Tax Issue:
Under Section 83(b) of the Internal Revenue Code, you can make an election of determining value of the option for tax purposes. It is simply a letter sent to the Internal Revenue Service advising them that you elect to be taxed on the value of your equity, such as shares of restricted stock, on the date the equity was granted rather than on the date the equity vests. Note that that Section 83(b) elections are only applicable for stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant. Put simply, it accelerates your ordinary income tax payable and selects if it will be taxed at the initial value or the value when vested.
Note the tax laws are in flux, so be sure to get up to date advice from your relevant advisors.
To provide some simple tax background, there are different types of tax rates. While rates are changing based on the current acts of Congress, an example from 2014 will give you some concept of the issues. The maximum ordinary income tax rate in 2014 is 39.6%, whereas the maximum long-term capital gains rate in 2014 is 20%. Because the United States uses graduated tax rates (meaning the rates vary based on your income), you may actually be subject to lower rates, but in each case the long-term capital gains rate will be lower than the ordinary income tax rate.
Assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant (if a Section 83(b) election is filed), or at vesting (if no Section 83(b) election is filed), in each case at the applicable ordinary income tax rate. When you later sell your stock, assuming it has been more than one year from the date of grant (if a Section 83(b) election is filed), or more than one year from the date of vesting (if no Section 83(b) election is filed), the additional gain will be taxed at the applicable long-term capital gains rate. Because the long-term capital gains rate will be lower, the goal here is to get as much of your gain as possible taxed using that rate, rather than the ordinary income tax rate.
Examples
In each of the below examples, assume you receive 100,000 shares subject to vesting, worth $.01 per share at the time of grant, $1.00 per share at the time of vesting, and $5.00 per share when sold more than one year later. We’ll also assume you are subject to the maximum ordinary income tax rate and long-term capital gains rate. For simplicity, we will not discuss the employment tax or state tax consequences.
Example 1: Taking a 83(b) Election
In this example you timely file a Section 83(b) election within 30 days of the restricted stock grant, when your shares are worth $1,000. You pay ordinary income tax of $396 (i.e., $1,000 x 39.6%). Because you filed a Section 83(b) election, you do not have to pay tax when the stock vests, only on the later sale. On the later sale which occurs more than one year after the date of grant you recognize a taxable gain of $4.99 per share (not $5.00, because you get credit for the $.01 per share you already took into income), and pay additional tax of $99,800 (i.e., $499,000 x 20%). Your economic gain after tax? $399,804 (i.e., $500,000 minus $396 minus $99,800).
Example 2: Not Taking a 83(b) Election
In this example you do not file a Section 83(b) election. So, you pay no tax at grant (because the shares are unvested), but instead recognize income of $100,000 when the shares vest and thus have ordinary income tax of $39,600. On the later sale which occurs more than one year after the date of vesting you recognize a taxable gain of $4.00 per share (not $5.00, because you get credit for the $1.00 per share you already took into income), and pay additional tax of $80,000 (i.e., $400,000 x 20%). Your economic gain after tax? $380,400 (i.e., $500,000 minus $39,600 minus $80,000).
So, in the above example, filing a Section 83(b) election would have saved you $19,404.
Filing a Section 83(b) election also has two other benefits. It would have prevented you from having a $39,600 tax hit when the stock vested and it also starts your long-term capital gains holding period clock earlier – meaning that you get the long-term capital gains rate as long as the sale of your shares occurs more than a year after grant, rather than a year after vesting.
Why Not Always File 83b election?
Note that if you fail to send your letter within thirty days of receipt of the option or grant, you forever waive your right to so elect. That thirty days is critical, and you have to make a quick decision on whether to use it.
If you receive restricted stock worth a nominal amount, it virtually always makes sense to file one. However, what if instead of receiving 100,000 shares of restricted stock worth $.01 per share, you received 100,000 shares of restricted stock worth $1.00 per share? Filing a tax code Section 83(b) election would immediately cause you tens of thousands of dollars of tax. And if the company subsequently fails, and in particular if it fails before your stock vests, you likely would have been economically better off to not have filed a Section 83(b) election.
Bottom line – discuss with your individual tax advisor but remember that the filing must be made (if at all) within 30 days after the grant date of your restricted stock, as that is an absolute deadline that cannot be cured. And note that the grant date of your restricted stock is usually the date the board approves the grant, even if you don’t receive the restricted stock paperwork until later – so sometimes you need to be very efficient about making this decision and filing the correct paperwork.
Conclusion:
Part of the new world an owner of stock in the company one works for is the world of tax planning. If you elect to be an owner, it is up to you to know the tax law or hire people who can properly advise you. Only in that manner can you maximize the benefits available.