A vesting provision is a great tool when employees of a start-up company receive payment in the form of equity. It especially comes in handy if a founder or employee leaves the company right after receiving the stocks. This is because the vesting provision tells when and how shares of the company will be distributed to those entitled to receive it. Just like salaries, stocks received by individuals are taxable. The taxable amount will be the fair market value at the time of transfer.
When to make an 83(b) election
As a tax strategy, shareholders of companies who are expecting an increase on the value of their stocks in the future choose to make an 83(b) election. An 83(b) election is an option provided by the IRS for taxpayers. This allows them to pay for the tax on the value of the stocks subject to their vesting agreement at the present value. Often this proves to be a favorable choice over waiting for the actual vesting. This election should be made within 30 days after the receipt of the stock grant.
83(b) election in action
Let’s say that XYZ, Inc. is a start-up company. In exchange for services rendered by its employee, it has granted the employee 10,000 shares at $.01 per share (fair market value) subject to a two-year vesting period. The two-year vesting period is 50% for the first year and the remaining 50% for the second year. Let’s further assume that the employee has timely filed an 83(b) election with the IRS. After the grant, the employee will include the stocks received on his tax return. They’ll then pay the tax due for the 10,000 shares at $.01 per share. If the employee falls under the 24% tax bracket, he’s liable for $24. Upon vesting, the employee is no longer required to pay taxes on the shares received.
Without the 83(b) election
Without the 83(b) election, if the price increased to $2 per share after a year, the employee will pay tax due of $2,400 upon receipt of 5,000 shares. If the price increased to $3 per share after two years, the employee will have to pay $3,600 upon receipt of the remaining 5,000 shares. Through 83(b) election, the employee was able to save $5,976 on his tax due. However, this is not always the case. If stock’s value drops and 83(b) was filed, it will be a disadvantage since the taxpayer will be paying a higher amount at grant date.
Though it may seem that making an 83(b) election is always beneficial, it is always prudent for taxpayers to seek assistance from their tax preparer or tax attorney before making one.