Tax Planning with Stock Issued to Employees

by | Mar 3, 2020

Question:        I recently accepted a job with a startup company and was given shares of company stock at no cost to me in which I will vest over a period of years.  Do I have to pay tax on the shares I receive?

Answer:           As with most employee benefits which are provided for no consideration, you will be taxed on the value of the shares you receive.  The real question is not whether you will be taxed on the shares which have been issued to you but when the tax liability will be incurred. 

The general rule is that stock transferred to an employee in connection with the performance of services is taxable when the shares vest.  Vesting means an employee has a nonforfeitable right to the shares which have been issued. If employment is terminated, for example, and the employee’s share rights are forfeited, the employee has not vested in the share issuance. If the vesting occurs at one time, the tax liability will arise in full at that time.  If, as is more typically the case, the shares vest in increments over a period of years, then the tax liability for the shares will be taxable at each point in time that the shares vest.

Although the general rules of taxation will permit you to postpone the tax until the shares vest, this may not necessarily be the best alternative from a tax perspective.  If the non-vested company stock increases in value from the time of issuance, you may be paying a greater tax liability as the tax liability will be based on the value of the shares when the shares vest in the future. It may be more desirable to pay tax based on the value of the shares at the time of issue in circumstances where the share value is increasing.  

A special tax election allows you to do just that.  A so-called Section 83(b) election enables you to pay tax on the value of non-vested shares as if they were fully vested at the time of issuance.  The election must be made within 30 days of the share transfer.  A Section 83(b) election can permit you to save a considerable amount of tax, particularly where shares of start up companies are issued at a time when they have relatively little value.

Consider Jori who accepts employment with a startup company and receives 10,000 shares of company stock upon the commencement of her employment.  Also assume the shares have a current value of $1.00 per share and that after the first year of Jori’s employment, Jori vests in 15% of the shares issued to her and they will be worth $5 per share at that time.  Following normal tax principles, Jori will have $7,500 of taxable income in year two when the first of the issued shares vest (10,000 x 15% x $5). Jori will also pay tax upon each additional share issuance. If instead, Jori makes a timely Section 83(b) election, Jori will only be taxed on $10,000 of share value, the value of the shares at the time of issuance, with no further tax consequence.

A potential reduced tax liability is not the only advantage of a Section 83(b) election. Once the election is made, any gain from the sale of shares will be treated as a capital gain entitling the employee to potentially pay tax at more favorable capital gains tax rates. This contrasts with the tax situation when no election is made as each time shares vest, the income reported is ordinary income which is taxed at regular tax rates.

Section 83(b) elections do have drawbacks.  If the stock of a company decreases in value, the employee will have paid tax on a larger amount of share value at an earlier time.  Similarly, if an employee terminates employment with the employer before the shares vest, the employee will have paid tax on shares for which the employee never received any benefit. No deduction is allowed for the employee’s loss in these circumstances.  

There is no one size fits all solution in determining when to report taxable income for shares issued in connection with the performance of services. With a Section 83(b) election required to be made within thirty days of share issuance, an employee must make an educated guess on whether or not the share value will be higher at the time of vesting and whether the employee is likely to remain employed with the employer until vesting occurs.  

 

A version of this article was featured in Forbes.  Click here to see this version.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to Bruce Bell.