83(b) Election: Tax Consequences of Restricted Stock Purchases
U.S. Federal Income Tax Consequences of the Purchase of Restricted Stock or Restricted Units; Section 83(b) Election
The following summarizes certain U.S. federal income tax consequences of a taxpayer’s purchase of shares of capital stock in a corporation or units in a limited liability company (the “Equity”) that will be subject to vesting restrictions and possible forfeiture upon the occurrence of certain events.
Within 30 days of a taxpayer’s purchase of Equity the taxpayer must decide whether or not to make an election (and actually make the election) under Section 83(b) of the Internal Revenue Code of 1986, as amended (the “Code”). We recommend consulting with a tax advisor before making this decision.
Making the 83(b) Election
In general, by making an election under Section 83(b) of the Code (a “Section 83(b) Election”), the taxpayer chooses to have the U.S. federal income tax treatment of its purchase of the Equity determined at the time of “transfer” rather than at some later date when unrestricted ownership of the Equity “vests.”
If the taxpayer makes a Section 83(b) Election, it must include as compensation income for the year of transfer the difference, if any, between the fair market value of the Equity at the time of transfer and the price the taxpayer paid for the Equity (including the fair market value of any property transferred to the company in exchange for the Equity). If the price paid is equal to the full fair market value of the Equity, the taxpayer should incur no U.S. federal income tax liability as a result of the purchase. The value that the taxpayer ascribes to the Equity, however, is not binding on the Internal Revenue Service and may be challenged.
One advantage of making a Section 83(b) Election is that there will be no U.S. federal income tax consequences at the time when the Equity vests. In addition, if the taxpayer subsequently sells or otherwise disposes of the Equity in a taxable transaction, any appreciation in the value of the Equity since the taxpayer acquired it and made a Section 83(b) Election generally will be taxed as capital gain, rather than ordinary income. Also, the taxpayer’s holding period will start from the date it received the Equity, so if the taxpayer holds the Equity for longer than one year after it received the Equity, any gain realized on a subsequent sale of the Equity will be taxed generally as long-term capital gain.
There are also potential disadvantages to making a Section 83(b) Election. One disadvantage is that, if the taxpayer later forfeits the Equity, it will not be allowed a deduction for any amount it reported as income at the time of transfer or for any additional taxes it paid as a result of making the election. Another potential disadvantage is that it is extremely difficult for a taxpayer to revoke a Section 83(b) Election, and it is only possible in limited circumstances. For example, after the taxpayer makes such an election, the Internal Revenue Service may decide that the fair market value of the Equity at the time of transfer was greater than the value reported on the Section 83(b) Election and, consequently, that the amount of the compensation income was greater than the taxpayer reported. However, if the taxpayer over-reported the value of the Equity at the time of transfer, the taxpayer cannot revoke its earlier election and lower the value of the Equity (and its compensation income).
Not Making the 83(b) Election
If the taxpayer does not make the Section 83(b) Election, in any taxable year in which Equity vests the taxpayer will be required to include in its gross income as ordinary income the difference between the fair market value of the Equity at the time such Equity vests and the price it paid for the Equity. As a result, income that likely would have been taxable at capital gain rates upon sale if the taxpayer had made a Section 83(b) Election would be taxable at ordinary income rates upon vesting. One advantage to this approach is that the taxpayer pays no U.S. federal income tax until the Equity vests. An additional advantage exists if the taxpayer purchased the Equity at a price less than fair market value: if for any reason ownership of any Equity never vests, the taxpayer will not be taxed on the receipt of the unvested Equity.
There are, however, several significant disadvantages to taxation at the time of vesting. The first is that, because the fair market value of the Equity may be higher at the time of vesting than at the time of transfer, the taxpayer’s income tax liability may be greater if it is determined at the time of vesting rather than the time of transfer. Additional social security and employment taxes may also be incurred. Furthermore, the income tax paid at the time of vesting on any appreciation in the value of the Equity is computed at ordinary income rates, rather than capital gain rates (which may be lower), and the holding period for the Equity for purposes of determining whether income from the sale qualifies as long-term capital gain will not begin until the Equity has vested. A final disadvantage is that, if the Company is not publicly traded at the time of vesting, the Equity will be illiquid and (except in certain limited circumstances) may not be able to be sold to pay the U.S. federal income tax.
Instructions for Making a Section 83(b) Election
If the taxpayer decides to make the election, the taxpayer must complete an “Election to Include in Gross Income in Year of Transfer of Property Pursuant to Section 83(b) of the Internal Revenue Code” form, sign and date it, and file it with the Internal Revenue Service Office where the taxpayer files its annual tax returns when no payment is included with such returns. More information on Section 83(b) is available in IRS Publication Number 525 which is available on the Internal Revenue Service’s website. The taxpayer should consult a tax advisor to obtain and prepare the form. In addition, the taxpayer should make two copies of the form and (i) place one copy with the records of the Company and (ii) retain the other copy and attach it to the taxpayer’s U.S. federal income tax return for the applicable taxable year.
TO BE EFFECTIVE, THE ELECTION FORM MUST BE FILED WITH THE INTERNAL REVENUE SERVICE WITHIN THIRTY (30) DAYS AFTER THE PURCHASE OF THE EQUITY IN THE COMPANY.
Please note that the determination of the fair market value of the Equity should be made in consultation with the Company and the taxpayer’s tax advisor. The fair market value which the taxpayer indicates on the Section 83(b) Election form must be as of the date of transfer—which in this case is the date the taxpayer purchased the Equity.