The vesting of stock options over a period leads to the question, when does the employee pay taxes on the value of the equity received?
IRC 83(b) Vesting of Stock Awards and Tax Liability
IRC Section 83(b) allows a shareholder receiving stock for services that is subject to a substantial risk of forfeiture to recognize the value of the stock as income in the year distributed. This allows the shareholder to recognize the stock as income before the stock increases in value. This is incredibly valuable for startup entrepreneurs who expect rapid growth of the corpora4on and value of the shares of stock. The risk associated with making an IRC Section 83(b) election is that the value of the stock will decrease, as there is no subsequent deduction allowed to the taxpayer. In such a case, the shareholder incurs income tax on the higher value.
- Example: Sarah agrees to work for the corporation in exchange for salary and an equity holding in the company. She will receive 1% ownership stake in the company at the end of each year for 3 years (her vesting schedule). If she leaves the company prior to the end of 3 years, all of her stock interest is forfeited back to the corpora4on. The contingency that Sarah stay at the company 3 years before owning her equity interest constitutes a substantial risk of forfeiture. Under IRC Section 83(a), Sarah can defer recognition of the stock award as income until the end of year 3. If, however, she chooses to recognize the stock award as income at the time that it vests (at the end of each year), she can elect to do so under IRC Section 83(b). Electing to recognize the income in the year awarded may lower her tax liability, as the stock will likely rise in value. If she waits until the end of year 3 to recognize the total value of the vested stock, she will pay income on the present value of the stock at that time.
- Note: Shareholders may not want or be able to pay the taxes on issues of stock for services, as she does not receive any cash along with the stock. In such a case, the shareholder may negotiate with the corporation to provide a bonus, known as a “gross up payment”, to cover the taxes on the value of the stock received.