Here’s a Partial Fix for the Section 83(b) Election Tax Problem
A recurring issue for many business lawyers involves an employee who receives stock subject to vesting conditions. The normal approach is to have the employee file a “Section 83(b) election” with the IRS within 30 days of receiving the stock. The Section 83(b) election is an election to recognize any income associated with the stock grant immediately upon receipt of the stock. If the employee does not file the Section 83(b) election within 30 days of the grant date, the employee is generally forced to recognize the stock value as income as he or she satisfies the vesting conditions – which will often happen at a time when the stock has appreciated and the amount of taxable income has correspondingly increased.
An employee cannot file a late Section 83(b) election. The short 30-day leash is mandated by the Internal Revenue Code; the IRS has no discretion to extend the time period for filing.
So, what to do? If the stock grant was legally ineffective, due to lack of Board authorization or other failures in issuing formalities, it might be possible to argue that no real grant took place notwithstanding the employee’s intentions; a current, corrective grant of stock could restart the 30-day clock for filing the Section 83(b) election. But if the initial grant was legally effective, the employee will often seek some way of stopping future recognition of income as the vesting milestones are met.
Many practitioners are using a technique that will cause a current inclusion in the employee’s income, thereby cutting off the employee’s future exposure to additional tax liability as the stock appreciates. This technique would also allow the continuation of any vesting conditions that the employer wants to retain so as to ensure the continued loyalty of the employee.
Section 83 of the Internal Revenue Code states that stock value will become taxable to an employee when vesting conditions are satisfied or, if earlier, at the time the employee can transfer the stock to a third party with the third party not being bound by any risk of forfeiture. This has led lawyers to amend an employee’s stock restrictions to provide that the employee can transfer shares to a third party even if the shares are not vested, but that the employee (and not the employee’s transferee) will be obligated to reimburse the employer if the employee fails to satisfy the vesting conditions. The employee would take on the contractual obligation to pay the employer the excess of the value of any unvested shares over the employee’s purchase price for the shares if the employee fails to meet the relevant vesting conditions. Since the employee’s transferee would not face any forfeiture conditions, the shares would cease to be subject to further Section 83 overhang at the time this form of transfer is permitted, even if the employee does not actually transfer the shares to anyone.
This would not allow the employee to compute his Section 83 tax liability based on the date-of-grant value of the stock. But it would allow the employee to base tax liability on the stock value as of the date of the transferability amendment, stopping the tax bleeding. And the employer would retain any golden handcuffs effect of the original vesting restrictions, because the employee would remain economically committed to reimburse the employer if the employee does not meet the original vesting conditions.
The IRS occasionally talks about reversing the 83(b) election presumption, by assuming the election is made unless the employee affirmatively files a statement indicating that it does not wish to have the benefits of the election. That would be a welcome change in the law. But until that occurs, keep in mind the transferability-amendment approach if you have a client come to you after the 30-day election period has expired.
This article originally appeared in the ACBA Business Section’s February Newsletter. Read the full newsletter here. To join the Business Section for only $35, please contact our membership department at firstname.lastname@example.org or call (510) 302-2200. Check out the ACBA Business Section’s webpage here for upcoming events and business law updates.
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