When an employee or service provider receives stock that is subject to vesting, they should immediately consider how that stock might be treated under Section 83 of the Internal Revenue Code. Stock grants subject to Section 83 sometimes occur when an employee or service provider receives restricted stock under a share purchase agreement or any company stock option plans that allows the employee or service provider to exercise the stock option prior to the vesting of that option. In these instances (including others, which you should discuss with a tax or legal advisor) the stock grant might trigger an issue under Section 83 and should consider filing a Section 83(b) election.
1. How does Section 83 work and what is an 83(b) election?
Under Section 83, when an individual receives property, in this case restricted stock, the party is required to pay income tax on the difference between the price paid for the stock and the fair market value of that stock on the date that the stock vests. The individual is required to pay the difference when the stock vests even if she does not engage in a transaction to sell her shares.
To mitigate the tax burden for the difference between the price on the grant date and the vesting date, any recipient of restricted stock subject to vesting should file an 83(b) election. This filing will allow you to be taxed based on the stock price on the grant date instead of the vesting date. For example, if the price on the grant date has a value of $1.00 but later increases in value to $1,000, a party who files an 83(b) election will receive tax treatment on the value at $1.00 instead of paying tax on the vesting value of $1,000. The safe bet, therefore, is to make an 83(b) election if you believe the stock will increase in value (thus locking in tax treatment at the price on the grant date and therefore recognizing no income on the increased value of the stock on the vesting date) but even if you believe that the stock price will remain constant it is more advisable to make the filing. In addition to the favorable tax treatment, making the filing will also start the one-year holding period for long term capital gains treatment from the grant date instead of the later date when the stock vests.
2. What if I did not pay fair market value for my shares?
In a situation where an employee or service provider does not pay fair market value for the shares they receive from a company they may find themselves subject to income tax without receiving a tangible benefit. Let us look at the following example. An employee joins Acme Co., a technology company that has been in business for five years. Acme Co. issues the employee 1,000 shares of restricted stock, valued at $.01 per share. However, given Acme Co.’s five-year existence, revenue, and ownership of various forms of intellectual property, Acme Co.’s shares actually have a fair market value of $2.01 per share. If the employee files an 83(b) election the taxable amount would be on the difference between the fair market value of the shares and the amount paid so the employee would pay income tax on the $2,000 instead of the $10 expected when she purchased the shares well below fair market value at $.01 per share.
3. When must an 83(b) election be filed and what should it include?
A party who receives stock subject to Section 83 must file an 83(b) election no later than 30 days after the stock has been transferred.
When you file an 83(b) election it must include:
Name, address, and tax identification number (or social security number) of the recipient.
An adequate description of the shares, e.g., 1,000 shares of Acme Co.
The date on which the shares were transferred and the tax year for which the recipient is making the election.
The recipient must include any restrictions on the stock with the filing, e.g., “Stock may not be transferred prior to 18 months after the grant date.”
The fair market value of the shares at the time of the transfer.
The amount paid for the stock, if any.
A statement by the recipient confirming that she has provided the required copies of the 83(b) election.
While the IRS has not set out a specific form required for filing an 83(b) election it has provided some model language to use when making such a filing, which can be found here.
4. Is there anything else I must do when filing an 83(b) election?
As a precaution it is best when filing your 83(b) election to do so by certified mail, with return receipt requested. In addition, when making an election it is advisable to make two copies. The first should be attached to your tax return for the year you are claiming the election and the second copy should go to the company that granted you the stock.
If you are considering making an 83(b) election in connection with the receipt of restricted stock options please feel free to contact one of our attorneys at firstname.lastname@example.org or visit our website at www.rbernardllp.com to learn more about our services. Follow us on Twitter.