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April 7th, 2005
Executive Compensation: Avoid Unnecessary Taxes on Restricted Founders Equity
Start-up companies typically issue restricted stock to founders pursuant to Internal Revenue Code ("IRC") Section 351. To encourage founders to remain with the company, start-ups often attach vesting provisions to the stock. Managing the vesting of founders equity can be tricky, and simple mistakes can create significant, unanticipated income tax liabilities. One common error we've seen occurs when such founders fail to "elect" to pay income tax at the time of the issuance under IRC Section 83(b). This article identifies this trap and helps you avoid it.
Purpose of Restricted Stock
While issuers may craft any number of vesting provisions, start-up companies typically require a founder's restricted stock to vest incrementally over time, upon the completion of certain services or upon the occurrence of certain events. If the founder does not meet the vesting conditions, he or she loses all or a portion of the unvested stock. Typically, during the vesting period, the recipient may not sell or otherwise transfer any unvested shares.
Founder benefits. Founders benefit by sharing in the appreciation in the value of the company that results from their hard work. This benefit may be enhanced by electing to pay taxes, if any, at the time of the grant under Section 83(b). As discussed below, the election often leads to a lower tax bill for founders than the tax liability that would otherwise be incurred at the time the restrictions on the stock lapse. Also, the holding period for capital gains treatment begins when the risk that the founders will forfeit the shares back to the company ends. On the other hand, founders making a Section 83(b) election may begin the holding period for capital gains treatment at the time the restricted stock is issued. This difference may be important where the timing of a liquidating event is uncertain, and may permit the recipient to enjoy favorable capital gains rates.
Company benefits. Service or event-based vesting requirements incentivize founders to remain with the company until the stock vests - and hopefully longer.
Avoid Income Tax Trap
IRC Section 83(a) says that restricted stock is not taxable until the restrictions lapse. Therefore, the recipient will owe tax at ordinary income tax levels on the difference between the amount paid by the recipient at the time of issuance and the value of the stock on the date that the restrictions lapse. The stock could substantially appreciate in value during the vesting period, thereby creating a large, unforeseen tax liability.
Example: Founding Shareholders A, B and C (each a "Founder") form Acme Corporation on January 1, 2005. Each Founder purchases 15,000 shares for $0.01 per share. Since this is a transaction covered by IRC Section 351, there is no tax event on the sale. However, to ensure their commitment to the company, the Founders impose a three-year vesting schedule on their shares. The shares vest in three equal annual portions at the end of each 12 month period, provided that the respective Founder continues to work for the company. The unvested shares are not transferable. Each Founder remains with the company for the entire three-year term. The value increases to $4 per share in 2005, $8 in 2006, and $25 in 2007. Result: each Founder has taxable income of $20,000 in 2005 (5000 shares vested times $4/share); $40,000 in 2006 (5000 shares vested times $8/share); and $125,000 in 2007 (5000 shares vested times $25/share). Assuming a 40% tax bracket, the aggregate potential tax liability for each Founder is $74,000.
Section 83(b) Election Reduces Tax Liability
Founders need not suffer the potential tax exposure described above. That's because IRC Section 83(b) gives the Founders the opportunity to "elect" to pay -- at the time of the grant -- the tax (if any) on the difference between the amount paid for the shares and the fair market value of the shares. Thus, since the shares were purchased in a Section 351 transaction, there is no difference between the amount paid for the shares and their fair-market value, and a proper Section 83(b) election will result in zero tax liability upon issuance and receipt of the shares notwithstanding the vesting provisions. To obtain the benefit of the Section 83(b) election, however, the Founder must complete and file the Section 83(b) election within 30 days of the date of the stock grant.
What to include in election filing. While there is no specific Section 83(b) election form, the IRS requires a Section 83(b) election filing to contain the following information:
- founder name, address and taxpayer identification number (for individuals, their social security number);
- description of the shares received;
- date that shares were received, and the taxable year to which the grant relates;
- description of the restrictions on the shares;
- fair market value of the shares at the time the shares were received;
- amount, if any, that the founder paid for the stock; and
- a statement that copies of the Section 83(b) election have been furnished to the issuer of the shares (the company).
Contact us for more information about IRC Section 83(b) and other start-up company founder and executive compensation issues.
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