Equity Incentives

Tax implications related to shares that vest

If your shares are subject to vesting, how and when you are taxed on those "restricted shares" is governed by Section 83 of the Internal Revenue Code. Specifically, the tax consequences depend upon whether you make an election—known as a "Section 83(b) election"—under Section 83 or not.  

No 83(b) election. If you don't make a timely Section 83(b) election, then your purchase of the restricted shares is not a taxable event. So there is no tax resulting from your purchase of the shares. However, when the shares vest the difference between the fair market value of the shares that vest on the vesting date minus the amount you paid for the shares is treated as income to you (even though you aren't receiving any cash from that increase in value)—and you need to pay tax (at ordinary income rates) on that income. So there's another taxable event every time the shares vest (whether annually, quarterly, monthly or otherwise). Unfortunately this means that the better the company does and the more the stock increases in value, the bigger the tax burden. Note also that the capital gains holding period for the shares would not start until the day after the shares vest. When you ultimately sell the shares, the difference between the sale price and the fair market value on the vesting date would be capital gain or loss. 

A timely 83(b) election. By making a Section 83(b) election within 30 days of the date the restricted shares are transferred to you, you elect to make the purchase of the restricted shares a taxable event, because you are required to pay tax (at ordinary income rates) on the difference between the fair market value of the shares on the date of purchase and the amount that you pay for the shares. Why would you do that? Why would you elect to pay tax on an earlier date than you would otherwise need to if you didn't file the 83(b) election? Answer: Because in most cases for a startup company you will have paid fair market value for the shares (which, at incorporation, is usually nominal). So the taxable income (i.e., the difference between the fair market value and the purchase price) would be zero!  And if you filed the 83(b) election, vesting becomes a non-event for tax purposes—there is no income (and therefore no tax) on vesting!  Note that your capital gains holding period also starts earlier than if you didn't file an 83(b) election.

Here's an example of the difference: Let's assume you pay $0.01 per share for 100,000 restricted shares, and the fair market value per share on the date of purchase is also $0.01. Assume the shares vest annually over four years, and on the first anniversary the fair market value of each share is $2.00.  

If you timely file a Section 83(b) election, you elect to be taxed on the difference between the fair market value on the date of purchase ($0.01 per share) minus your purchase price (also $0.01 per share). So the tax on the date of purchase is zero. Vesting is not a taxable event and so you owe no tax on vesting. You only have to pay tax on the gain when you sell the shares.  

In contrast, if you do not file a Section 83(b) election, you effectively defer being taxed until vesting. So while there is no tax due on the date of purchase, you do have taxable income when the shares vest. So on the first anniversary when 25,000 shares vest, you have $49,750 in taxable income (25,000 shares x [$2.00 per share ˗ $0.01 per share]). That's a big tax bill when you aren't likely to even be able to sell your shares to cover the tax.  

Whether or not you decide to file a Section 83(b) election will ultimately depend on your particular facts and circumstances and you may want to consult with your own accountants or tax advisors before making the election.