A vesting provision is a great tool when employees of a start-up company receive payment in the form of equity, also referred to as vested stocks. It especially comes in handy if a founder or employee leaves the company right after receiving the stocks. This is because the vesting provision outlines clearly when and how shares of the company will be distributed to those entitled to receive it. Just like salaries, stocks that are received by individuals are taxable. The taxable amount will be the fair market value at the time of transfer.
Key Takeaways
- Vesting provisions: A mechanism for distributing company shares to employees over time, typically linked to their continued employment. Prevents early departure after receiving stocks distribution grants. Shares become taxable as they vest, based on their fair market value at that time.
- 83(b) election: A tax strategy for employees receiving stock with vesting provisions. Allows paying taxes on the stock’s current value, potentially at a lower rate than in the future. This must be done within 30 days of receiving the stock grant.
- Important notes: An 83(b) election isn’t always beneficial. If the stock price drops, taxes are based on the higher grant-date value. Consult a tax expert before making an 83(b) election.
What is the vesting provision when distributing stocks?
Start-up employees often welcome equity as part of their compensation. Vesting provisions are crucial in managing this equity, especially when team members leave soon after receiving shares. These provisions outline the timeline and conditions under which employees earn full ownership of the stock, preventing an immediate windfall if someone departs prematurely.
It’s important to remember that, like salaries, any stock received is taxable. The amount owed to the government depends on the fair market value of the shares when they’re transferred to the employee.
- Vesting asks employees to stay with the company for a specified period, aligning their interests with long-term success.
- Some vesting schedules tie vesting to achieving specific goals and motivating employees to contribute directly to the company’s growth.
- Vesting prevents mass exodus if the company faces short-term challenges, ensuring a stable workforce.
When to make an 83(b) election for vested stock
As a tax strategy, shareholders of companies who are expecting an increase in the value of their vested stocks in the future choose to make an 83(b) election. An 83(b) election is an option provided by the IRS for taxpayers. This allows them to pay for the tax on the value of the stocks subject to their vesting agreement at the present value. Often, this proves to be a favorable choice over waiting for the actual vesting. This election should be made within 30 days after the receipt of the stock grant. However, this strategy has risks too. If the stock value decreases, you’ll have paid taxes on a higher value, resulting in a loss.
83(b) election in action for vested stock
Let’s say that XYZ, Inc. is a start-up company. In exchange for services rendered by its employee, it has granted the employee 10,000 shares at $.01 per share (fair market value) subject to a two-year vesting period. The two-year vesting period is 50% for the first year and the remaining 50% for the second year.
Let’s further assume that the employee has filed an 83(b) election with the IRS in a timely manner. After the grant, the employee will include the stocks received on his tax return. The employee will then pay the tax due for the 10,000 shares at $.01 per share. If the employee falls under the 24% tax bracket, he’s liable for $24. Upon vesting, the employee is no longer required to pay taxes on the shares received.
If the stock price skyrockets to $10 per share after vesting, you’d normally pay $2,400 in taxes (10,000 shares * $10/share * 24% tax bracket). But thanks to the 83(b) election, you’ve already paid the taxes at the lower price, saving $2,376!
Verdict:
In this example, the 83(b) election saved nearly $2,400. However, it’s not guaranteed: If the stock price drops, you’ll have overpaid taxes.
Vested stock without the 83(b) election
Without the 83(b) election, if the price increases to $2 per share after a year, the employee will pay the tax due of $2,400 upon receipt of 5,000 shares. If the price increases to $3 per share after two years, the employee will have to pay $3,600 upon receipt of the remaining 5,000 shares. Through 83(b) election for their vested stock, the employee was able to save $5,976 on his tax due. However, this scenario is not always the case. If the stock’s value drops and 83(b) was filed, it will be a disadvantage since the taxpayer will be paying a higher amount at grant date.
Though it may seem that making an 83(b) election for their vested stock will always yield beneficial outcomes, taxpayers should always seek assistance from their tax preparer or tax attorney before making one.
Comparison:
By choosing the 83(b) election in this example, you saved $7,200 (without 83(b)) – $24 (with 83(b)) = $7,176 in taxes.
The 83(b) election can be highly beneficial when you expect stock price appreciation. However, remember:
- Downside risk: If the stock price decreases, you’ll have paid taxes on a higher value, resulting in a loss.
- Seek professional advice: Tax implications are complex and can vary depending on your individual circumstances. Consult a tax advisor before making the 83(b) election.
- This example assumes federal taxes. State and local taxes may apply.
- The 83(b) election can impact the company’s financial statements.
Can Cleer Tax help me file an 83(b) election for vested stock?
Absolutely! At Cleer Tax, our dedicated team is committed to addressing your business’s distinct requirements.
We provide comprehensive tax advisory services tailored to your specific needs, covering every aspect of compliance and optimization. Our goal is to ensure that you capitalize on every available opportunity, leaving no stone unturned when maximizing your tax benefits and minimizing any potential liabilities.
Cleer can help you file your 83(b) election with ease. Trust Cleer to guide you through the 83(b) election process, ensuring accuracy and avoiding common errors. Our expertise in assisting founders guarantees that your potential payout is maximized and protected.
If you need any help, schedule a consultation to discuss it further, or feel free to contact us.
