Stock options can be a very effective way for early-stage businesses to attract and retain talent. While offering stock options can be an easy and seemingly inexpensive way to hold on to talented workers, there are a few tax rules to keep in mind. In this blog, we’ll explore the most common and relevant tax code section related to using stock or stock options as part of a worker’s compensation – Internal Revenue Code § 83.
Stock as Taxable Income
The first thing any business, and worker, should consider when using stock as part of a compensation package is whether the stock, or stock option, will be treated as taxable income. Internal Revenue Code § 83 is a tax provision that applies to property, including stock and stock options, transferred to an employee in connection with the performance of services. Under § 83, the value of the property transferred is generally included in the employee’s gross income in the taxable year in which the property becomes vested. The value of the property is generally equal to the fair market value of the property at the time of vesting, minus any amount paid by the employee for that property.
Stock as Equity Compensation
§ 83 is of increased importance because it affects the tax treatment of equity compensation for both employers and employees. Employers need to be aware of § 83 when the following conditions apply:
- Designing equity compensation plans and granting equity to employees, as it can impact the amount and timing of tax deductions that the employer can claim.
- When receiving equity compensation, as it can impact the amount and timing of taxes that they owe.
An employee who receives equity compensation that is subject to § 83 may owe taxes on the value of the property when it becomes vested, even if they have not yet sold the property. This can create a cash flow issue for employees who may not have the funds available to pay the taxes owed, as well as coming as a surprise to the employee who most likely didn’t expect to have a tax liability on the options or shares they received.
Because of its potential impact on both employers and employees, it is important to understand § 83 implications when designing, granting, and receiving equity compensation. Fortunately, in most cases, an election under IRC § 83(b) most likely addresses everyone’s concerns.
Internal Revenue Code §83(b) election
“§83(b) election” refers to a provision in the United States Internal Revenue Code (IRC) Section 83(b). This section applies to compensatory stock options, restricted stock units (RSUs), and other forms of equity-based compensation that are granted to employees, consultants, or other service providers by their employers or clients. When a person receives equity-based compensation, like stock options or RSUs, there is often a vesting period during which they do not fully own or have the right to the equity. Vesting is a process by which an individual gains ownership rights to the equity over a certain period of time or upon the achievement of specific milestones.
The §83(b) election allows an individual to choose how they want to be taxed on the value of the equity they receive during the vesting period. Here’s how it works:
- Standard Taxation: Without making an 83(b) election, an individual would typically be taxed on the value of the equity at the time it vests. This means that as the equity vests over time, the individual’s taxable income increases accordingly. For example, if an employee is granted stock options that vest over a four-year period and the value of the stock increases during that time, the employee will be taxed on the higher value as the options vested.
- 83(b) Election: By making an §83(b) election, an individual chooses to include the value of the equity at the time it was granted (not at vesting) in their taxable income for the current tax year, even though the equity has not yet fully vested. This can be advantageous if the equity’s value will most likely be fairly low at the time of grant and is expected to appreciate significantly by the time it vests.
By paying taxes on the lower grant value, the employee can expect to end up paying less in taxes compared to waiting until vesting. In addition, if the employee holds the equity for more than one year after making the election, any future appreciation in value will most likely be treated as long-term capital gain, resulting in a lower tax rate compared to ordinary income tax rates.
There are some risks, however. If the election is taken and the equity doesn’t end up vesting due to job loss or other reasons, the taxpayer will not get a refund for the taxes paid on the unvested equity. Also, the taxpayer will need to pay taxes on the value of the equity at grant immediately, even if they haven’t received any cash from it.
On balance, making the election under §83(b) is a good thing for both the start-up and the worker. Interested in learning more about developing stock option plans?