Stock as Equity Compensation
In general, Internal Revenue Code §83 determines the consequences of the transfer of property in connection with the performance of services. Essentially, when an employee or an independent contractor receives stock (e.g., property), he or she must include in income (e.g., as ordinary income because the receipt of stock for services is equivalent to salary) the fair market value of stock received, minus any amounts paid for the stock.

However, the timing of when the employee includes such amount in income only occurs when the stock either becomes "vested" or transferable (e.g., by the employee), at which point the employer is entitled to a corresponding deduction. ("Vested" is a term commonly used to refer to stock when the recipient acquires all ownership rights in the stock without the possibility of losing or forfeiting the stock. Under §83(a) and §83(c)(1), "vesting" is more technically defined as the lapse of a substantial risk of forfeiture.)

Rarely does a company grant stock to an employee outright. Rather, the stock is "restricted stock," meaning the employee only becomes entitled to ownership of the stock upon the occurrence of some event, such as remaining employed with the company for a period of time or achieving some objective for the company.

Example: Suppose Employer transfers 10 shares of stock to Employee on January 1, 2000 (worth $1.00 at the time of the transfer), however, the stock vests ratably over 5 years of continued employment. If Employee remains employed for a year from the date of the grant, Employee must include 1/5 of the fair market value in income, which is determined by the fair market value of the stock on January 1, 2001. Suppose the company is a startup company, which goes public in December 2000, and because of its desirable business-to-business software, its stock price rockets to $200.00 a share by January 1, 2001. Employee would have to include 1/5 of $200.00 ($40) in income for his 2001 taxable year. Should Employee remain employed with Employer through January 1, 2005, he would have to include in income for each portion of the stock vesting an amount equal to the difference between the fair market value on the vesting date and the price he paid for the stock. For instance if the stock rose to $210 a share on January 1, 2002, then Employee would have to include 1/5 of $210 ($42) for his 2002 taxable year. Employee would have to recognize a corresponding amount for each year he remained employed with Employer until his stock had completely vested (e.g., by January 1, 2005).

This does not appear fair to Employee, who essentially gets punished with higher taxes for helping to build an incredibly valuable company (according to the stock market). However, Employee can make an election, which would accelerate the timing of the taxation of his stock to the year of the transfer of the stock, which would be the grant date (year 2000 in the Example), as opposed to when the stock vests over the course of the vesting schedule for the stock.

The §83(b) Election
Commonly referred to as the "§83(b) Election," this election can greatly reduce the tax impact of receiving stock if the stock has the potential to increase dramatically over the course of its vesting period. Although the requirements for an election under §83(b) are both simple and set forth explicitly in the Treasury Regulations, the most important point of which to beware is that the election must be made (which means it must be mailed to the IRS) within 30 days after the transfer of stock.

For instance, in the Example, had Employee made a §83(b) Election on or before January 1, 2000, he would only have included in income 1/5 of $10.00 ($2.00) in year 2000. In contrast, without making the election, Employee would have included $40 and $42 in income for the years 2001 and 2002 respectively, as well as additional amounts for each year through 2005, until his stock had totally vested.

In spite of the huge benefits of the §83(b) Election, there is some risk where the employee pays less than fair market value for the stock. If the employment relationship ends before the stock vests, the employee is not entitled to a deduction to offset the tax he paid as a result of making the election in the year of the stock grant.

For instance, in the Example, if Employee makes the §83(b) Election, he pays $10 in tax for the 2000 taxable year. If Employee is fired or leaves the company before any stock has vested (e.g., before January 2001), then Employee forfeits all of his stock. The Employee's taxable loss is measured by the difference between the amount Employer paid for his stock upon forfeiture ($0) and the amount he paid for the stock at the grant date ($0). So, Employee has no taxable loss upon forfeiture according to the facts of the Example.

Finally, when the employee subsequently sells the stock, he recognizes gain equal to the difference between the price received for the stock and his basis in the stock -- the amount he paid for the stock, plus the amount of ordinary income he recognized for receiving the stock (e.g., determined either when the stock vested or when he made the §83(b) election). The holding period for determining whether the stock qualifies for long-term capital gain also begins immediately after the stock vests or when the employee makes the §83(b) Election.

It is important to note that before §83 is invoked, and therefore before an employee can actually make an election under §83(b), there actually must be a "transfer" of stock. Although this seems like a no-brainer, the transfer of an option to purchase stock is generally not considered to constitute a transfer for the purposes of §83 with respect to the stock underlying the option.

Additionally, the option itself does not constitute a transfer unless:

1) the option is a nonqualified stock option (e.g., does not constitute an incentive stock option), and
2) the company has options that trade on a public market. (See generally §1.83-3(a), 1.83-7.)

There is one very practical situation in which the transfer of stock can be treated as an option, which would therefore preclude an election under §83(b) and have disastrous consequences if an employee desired to make the election. A company is often inclined to require its employees receiving a grant of restricted stock to purchase the stock for fair market value at the date of the grant. The arrangement could be advantageous for general accounting purposes, the company might want to avoid tax withholding problems or the company might want to offer restricted stock on terms similar to the terms of an incentive stock option.

However, the employee might not either desire or possess the money to purchase the restricted stock upon the date of the grant, because he does not obtain unfettered ownership in the stock until the occurrence of some future event. As a result, the company may be willing to loan the money to the employee.

If the loan is structured as a non-recourse loan that is not secured by property at least equal to the fair market value of the underlying stock on the grant date, then the Internal Revenue Service will characterize the arrangement as an option to purchase stock. According to this approach, §83 would not apply until the employee pays off the balance of the loan, at which point the employee would include in income the difference between the fair market value of the stock (determined as of the date of the loan payoff) and the amount paid for the stock (the loan payoff amount).

Example #2: Building on the first Example, suppose Employer grants Employee 10 shares of stock with a fair market value of $1.00 on January 1, 2000, and requires the employee to purchase the stock for $1.00 a share. To facilitate the purchase, Employer loans Employee $10.00. Employee files a §83(b) Election with the IRS on January 2, 2000. The stock climbs to $200.00 on January 1, 2001, at which time 1/5 vests. Feeling confident that the stock will not decline in value below $1.00 a share, Employee pays off the loan balance. If the loan was non-recourse, without sufficient loan security (e.g., other property with a fair market value equal to the loan balance), then the IRS will require Employee to recognize the difference between the loan balance of $10 (e.g., assuming no interest on such a nominal loan) and $2,000 in income for the year 2001. The §83(b) Election was invalid, because a "transfer" did not occur on the grant date of the restricted stock (e.g., January 1, 2000).

One might be inclined to question whether stock would fall under the ambit of §83 if transferred to an employee who pays the company an amount equal to the fair market value of the stock? §83 can apply to a purchase at fair market value if the transfer is compensatory.

Although this is a complicated issue, which should be explored at length according to the facts of any given situation, generally a transfer for fair market value will be treated as compensatory in nature, unless the employee receiving the stock can prove that other parties would able to purchase stock from the company on the same or similar terms.

First published on June 5, 2000.