Tax planning is a critical part of running a small business, or starting a new one. Some tax issues determine how a business may proceed, while others can only be addressed once the business has made a decision. Depending on the type of business entity chosen, income tax may be assessed against the business itself, the owners, or both. Businesses must also be aware of tax issues affecting their employees, including officers. The Internal Revenue Code (IRC) provides multiple options for both companies and their employees with regard to taxation of income. When a business compensates an employee, or any other “service provider,” with certain types of equity incentives, Section 83(b) of the IRC, 26 U.S.C. § 83(b), offers certain advantages that businesses—particularly small businesses and start-ups—should consider.
Businesses typically compensate employees with cash payments, either on an hourly or salaried basis, along with health insurance and various “perks.” Start-ups might compensate employees, contractors, and others with company stock or stock options during the early start-up phases. Established companies might grant shares of stock to employees as direct compensation, or as a bonus to provide incentives for performance. Two important questions arise from this sort of compensation: when does the grant of certain types of equity constitute a taxable event, and how is it valued?
Section 83(b) deals specifically with equity incentives that are subject to vesting. For example, a grant of 10,000 shares of stock subject to a four-year vesting schedule would mean that one-fourth of the total shares, or 2,500 shares, become available to the employee at the end of each year. For a person who elects Section 83(b) taxation, the taxable event is the initial grant of the unvested stocks, meaning that the taxable income is based on the fair market value of the stocks at that point in time. Otherwise, the taxable event might occur when the stocks vest. Presumably, the stocks are worth less when the initial grant occurs, and more when they vest. Section 83(b) therefore reduces the overall taxable amount.
To build on the earlier example, suppose the company stock is worth $1/share at the time the company grants 10,000 unvested shares to the employee, and that the stock goes up in value by fifteen percent each year. Under Section 83(b), the total taxable income would be $10,000. Without a Section 83(b) election, the employee’s total taxable income would be $13,975:
|Year||Stock Price||Vested Shares||Taxable Income|
The benefit of a Section 83(b) election, at least under these sorts of circumstances, should be clear. The main drawback is that the election is irrevocable. Since the primary benefit is based on maintaining a low tax basis as the value of the stock increases, the benefit is diminished, or may disappear entirely, if the stock’s fair market value goes down.
Business attorney Samuel C. Berger represents businesses, business owners, and entrepreneurs in New York and New Jersey. We offer fixed-fee legal-service packages that cover a broad range of legal needs for our clients. To schedule a confidential consultation to see how we can help you and your business, please contact us today online, at (201) 587-1500, or at (212) 380-8117.
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