Putting stock in the future: How startup employees can navigate their options
Employees with restricted stock should evaluate the company’s outlook – and consult with an experienced tax advisor when deciding on the right tax treatment
Editor’s note: The 2017 Tax Cuts and Jobs Act added Code Sec. 83(i) which allows employees of privately held companies to defer recognizing income from stock received on exercise of an option or settlement of an RSU until the opportunity to sell some of the stock arises, but no later than five years from the date that the employee’s right to stock becomes “substantially vested”. This election cannot be made for qualified stock if the employee has made a Code Sec. 83(b) election to report income in the year the non-vested property is received. One should consider this new provision when making the decision to make a Code Sec. 83(b) election.
Working for a startup can be rewarding.
Small teams work collaboratively to solve big problems. Employees produce results with an intense focus that comes with personal investment in their own success. There are bottomless pots of coffee.
In reality, working for a startup is every bit as challenging as it is rewarding. In the early years, these companies frequently experience cash-flow shortages. Often, the largest single drain on cash flow is wages. So, to preserve cash and incent employees to stay on, companies sometimes offer employees a stake in the company in lieu of their full salaries. Then, if the startup “exits” through an initial public offering or acquisition, employees can be rewarded with substantial payouts.
The ownership stake offered to employees usually comes in the form of restricted stock.
Before participating in a restricted stock agreement, employees should first ask themselves several important questions about the company and their personal motivations for working there:
- Do I believe that the company, its people, and the market opportunity will greatly increase the value of the company stock?
- Can I afford to work at below-market wages, possibly for years, for a potential payoff at some point in the future?
- Am I willing to remain employed with the company until the completion of the project?
If employees have confidence that the company’s stock will increase in value over time, and that they can stick with the job, they may decide to pursue a particular tax treatment of their restricted stock, which this article will discuss.
Employees who receive restricted stock can’t transfer it until certain restrictions are met, and they take on risk that they will lose any right to the stock if those restrictions are not met. This is called “substantial risk of forfeiture.”
For example, a restricted stock agreement might state that an employee must remain employed with the startup for five years before selling the stock. In that case, there’s a real possibility that the employee will leave the job in that time and would have to forfeit the stock. And, depending on the employee’s tax decisions in regard to the restricted stock, the employee could even end up losing money.
The tax law is complicated in this area. Taxpayers must properly notify the IRS of certain actions they might take in regard to their restricted stock. It pays to consult a tax professional in these matters.
The tax choice
Employees who receive restricted stock have a choice that affects when and how the stock is taxed.
Usually, employees who receive restricted stock pay tax on the difference between the stock’s fair market value (FMV) in the year the stock vests (meaning, after any restrictions lapse) and the exercise price (meaning the amount the employee pays for the stock). This difference is included in taxable wages on the employee’s Form W-2. The holding period starts on the date the stock vests. The holding period determines whether any eventual proceeds will be taxed as short- or long-term capital gains. The basis of the now-vested shares includes the amount paid for the shares (if any), plus any amount includible in gross income as compensation due to the vesting of the shares.
Alternatively, an employee can make an “§83(b) election” in the year restricted stock is granted. An §83(b) election would include in gross income the difference between the exercise price and the FMV of the stock on the grant date. In this case, no income will be reported when the shares vest, and the holding period starts on the date the restricted stock is granted. Once vested, the basis of the shares includes the amount paid (if any), plus any amount includible in gross income as compensation due to the §83(b) election.
While the §83(b) election is available to employees who receive restricted stock, it is not available to those who are given restricted stock units (RSUs). The difference is that, under a nonqualified restricted stock plan, there is an actual transfer of property to the employee on the grant date, while with RSUs, the employee is granted only a legally binding right to receive the property in a future year.
The advantages of an §83(b) election
The §83(b) election is usually beneficial if the restricted stock is from a new or startup company and has relatively little value when it is granted but has the potential for a much higher value when the stock vests.
For example, Phil and Don are hired by EVR Co. in 2015. Each is granted 1,000 restricted shares of EVR stock, which will be fully vested after two years. The FMV of the stock is $2 per share when it is granted; the exercise price for the stock is zero. Phil makes an §83(b) election in 2015. EVR Co. must include $2,000 ($2 × 1,000 shares) in his W-2 compensation, subject to income and payroll taxes. Don does not make the election and doesn’t have to include the additional income in 2015.
When the stock vests two years later, EVR is valued at $15 per share. In Don’s case, EVR Co. must include $15,000 ($15 × 1,000 shares) in his W-2 compensation, subject to ordinary income tax rates and payroll taxes. In Phil’s case, because he made the §83(b) election in 2015, he isn’t required to include any additional income on his return when the stock vests in 2017.
The disadvantages of an §83(b) election
Despite the potential advantages, there can be risks in completing an §83(b) election. If the employee forfeits the restricted stock (which generally happens when the individual leaves the company before the stock vests), or if the value of the stock depreciates, the income included in wages under the §83(b) election does not create or increase basis in the stock for loss purposes. That means if the taxpayer didn’t pay anything for the restricted stock and it is forfeited, the taxpayer can’t deduct a loss or get any credit for taxes paid for the amount previously included in income on his or her tax return.
Varying the example above, in 2015, Phil and Don are each granted 1,000 restricted shares of EVR stock, which will be fully vested after two years. The FMV of the stock is $2 per share when it is granted; the exercise price for the stock is $1. Phil makes an §83(b) election in 2015. EVR Co. must include $1,000 [($2-$1) × 1,000 shares] in his W-2 compensation, subject to income and payroll taxes on his 2015 return. Don does not make the election and doesn’t have to include the additional income in 2015.
Both Phil and Don leave EVR Co. in 2016, before their restricted stock vests, and it is forfeited. The forfeiture results in a deemed sale of the restricted stock reported on Form 8949, Sales and Other Dispositions of Capital Assets. For Phil and Don, the recognized loss is the difference between the sales price (which is zero, assuming they didn’t receive anything from EVR Co. for the forfeiture), and $1,000, the amount paid for the stock. In Phil’s case, even though he made the §83(b) election and included $1,000 as additional compensation in 2015, he isn’t allowed to include that additional income in his stock’s basis.
For illustrations see Rev. Proc. 2012-29, examples 4-6.
Making the election
Employees who want to make the §83(b) election must file an election statement with their employer and the IRS within 30 days of receiving the restricted stock grant. The election must follow specific guidelines and provide detailed information about the stock. It should also be mailed to an IRS service center specific to the taxpayer’s location.
Effective July 26, 2016, Final Reg. §1.83-2(c) removes the requirement for taxpayers to attach a copy of the §83(b) election with their tax returns for the year the election was made, and allows these taxpayers to electronically file their returns.
Once an §83(b) election is made, it can't be revoked without the IRS’s consent.
Evaluate the pros and cons
When deciding whether to make an §83(b) election, and when actually making the election, it’s important for taxpayers to evaluate the outlook for themselves and the company, and to consult with a tax professional to understand the potential benefits and disadvantages of this tax treatment.