83(b) Elections and Restricted Stock

Employee compensation is always an issue for start up companies, who are typically not immediately generating positive cash flow but still need talent to help run the business.  Thier are a number of ways to do this.  One way is for the company to grant what’s known as “restricted stock”, which is stock which “vests” over a period of time.  Prior to the stock vesting, it can be forfeited back to the company upon termination of employment.   Typically, the grant of unvested stock is not a taxable event, since the employee did not really receive anything of value.  The date on which the stock vests would normally be the date the employee would be liable for taxes on the grant of stock. 

This, however, can be quite a tax hit to the employee.  Say, for example, that on the date the restricted stock is granted to the employee, the company is worth $1 and assume the stock vests over a 1 year term.  If the value of the company increases over than one year term from $1 to $1000, the employee will take an ordinary income tax hit on the equity grant that is 1000x higher than the tax she would have paid on the initial grant date (which would have been zero if she paid fair market value of the stock – see below).  To satisfy this tax hit, the employee has to come out of pocket.  If you add some more zeroes to the ends of these number, you can be talking about some serious tax liability. 

Fortunately, this result is avoidable by making what is known as a Rule 83(b) election under the Internal Revenue Code.    If the employee makes this election, ordinary income is recognized when the initial grant is made – which is typically zero since the purchase of the stock is made at the company’s fair market value (since at inception, the fair market value is relatively low).  Thus, when the restricted stock vests, no income tax is due, and the only future taxable event occurs when the stock is later sold by the employee.   The election needs to be made timely – that is, within 30 days of the initial date of grant.  Great care should be taken that these rules are followed meticulously.

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