When a company is first starting, or expecting to grow significantly, paying cash to employees or independent contractors may be difficult.
When a company is first starting, or expecting to grow significantly, paying cash to employees or independent contractors may be difficult. As an alternative, the company may decide to grant restricted stock options with a vesting schedule so compensation can be made over time and without depleting cash. This strategy is especially useful for start-up companies.
Under normal circumstances, the recipient of the stock would be granted the options with a vesting schedule. Ordinary income is recognized when the shares vest, at the exercise price. However, if the value of the shares is expected to be higher on the exercise date, then the recipient has the option to file an 83(b) election within 30 days of the grant date and will pay tax on the value of the shares on that day, rather than when the shares vest.
Assume you receive 10,000 shares subject to vesting, worth $0.01 per share at the time of grant, $3.00 per share at the time of vesting, and $10.00 per share when sold. This example assumes the shares are sold over one year after vesting.
If a Section 83(b) election is filed within 30 days of the restricted stock grant, the shares would be worth $100, and tax would be paid at ordinary income tax rates. Because the Section 83(b) election was made, there is no tax when the stock vests. When sold, the taxable gain is $9.99 per share ($10 less the $0.01 amount at election), which would be taxed at the capital gains rate.
If no Section 83(b) election is filed, no tax is paid at the grant date. However, income of $30,000 is recognized when the shares vest, which will be taxed as ordinary income. When sold, a taxable gain is $7.00 per share ($10 less $3 amount when vested), which would be taxed at the capital gains rate.
In this example, the tax savings is the difference between the ordinary and capital tax rates on $29,900 of income. So, if you are in the 24% tax bracket with a capital gains rate of 15%, the tax savings would be $2,691 by making the election.
What are the risks?
However, the section 83(b) election is not always advantageous. If the stock value drops after the election is made, then more tax will be paid up front than what would have been due without it. Also, tax is paid in the year the election is made, so there may be a significant tax bill if the initial value of the stock is high. Reviewing the current value of company and where it is projected to go is a necessary step prior to submitting the election to the IRS. Once made, the election cannot be undone.
If you want more information on the section 83(b) election or need help with tax planning and preparation, contact our tax professionals at The Innovative CPA Group at 203-489-0612. Or contact us online.