US Income Tax Advisory Section 83b Election
U.S. Federal Income Tax Consequences of Purchase of Restricted Stock; Section 83(b) Election
Thomas D. Herman, Esq., Smith Duggan Buell & Rufo LLP
This Client Advisory summarizes certain U.S. federal income tax consequences of a taxpayer’s purchase of shares of capital stock in a corporation (the “Shares”) that will be subject to vesting restrictions and possible forfeiture upon the occurrence of certain events.
Within 30 days of a taxpayer’s purchase of Shares the taxpayer must decide whether or not to make an election (and actually make the election) under Section 83(b) of the Internal Revenue Code of 1986, as amended (the “Code”). We recommend consulting with a tax advisor before making this decision.
Making the 83(b) Election
In general, by making an election under Section 83(b) of the Code (a “Section 83(b) Election”), the taxpayer chooses to have the U.S. federal income tax treatment of its purchase of the Shares determined at the time of “transfer” (e.g., when the shares were received) rather than at some later date when unrestricted ownership of the Shares “vests.”
If the taxpayer makes a Section 83(b) Election, it must include as compensation income for the year of transfer the difference, if any, between the fair market value of the Shares at the time of transfer and the price the taxpayer paid for the Shares. If the price paid is equal to the full fair market value of the Shares, the taxpayer should incur no U.S. federal income tax liability as a result of the purchase. The value that the taxpayer ascribes to the Shares, however, is not binding on the Internal Revenue Service and may be challenged.
One advantage of making a Section 83(b) Election is that there will be no U.S. federal income tax consequences at the time when the Shares vest. In addition, if the taxpayer subsequently sells or otherwise disposes of the Shares in a taxable transaction, any appreciation in the value of the Shares since the taxpayer acquired them and made a Section 83(b) Election will be taxed as capital gain, rather than ordinary income. Also, the taxpayer’s holding period will start from the date it received the Shares, so if the taxpayer holds the Shares for longer than one year after it received them, any gain realized on a subsequent sale of the Shares will be taxed as long-term capital gain.
There are also potential disadvantages to making a Section 83(b) Election. One disadvantage is that, if the taxpayer later forfeits the Shares, it will not be allowed a deduction for any amount it reported as income at the time of transfer or for any additional taxes it paid as a result of making the election. Another potential disadvantage is that the taxpayer cannot revoke a Section 83(b) Election. For example, after the taxpayer makes such an election, the Internal Revenue Service may decide that the fair market value of the Shares at the time of transfer was greater than the value reported on the Section 83(b) Election and, consequently, that the amount of your compensation income was greater than the taxpayer reported.
Not Making the 83(b) Election
If the taxpayer does not make the Section 83(b) Election, in any taxable year in which shares vest it will be required to include in its gross income as ordinary income the difference between the fair market value of the Shares at the time such Shares vest and the price it paid for the Shares. As a result, income that likely would have been taxable at capital gain rates upon sale if it had made a Section 83(b) Election would be taxable at ordinary income rates upon vesting. One advantage to this approach is that the taxpayer pays no U.S. federal income tax until the Shares vest. An additional advantage exists if the taxpayer purchased the Shares at a price less than fair market value: if for any reason ownership of any Shares never vests, the taxpayer will not be taxed on the receipt of the unvested Shares.
There are, however, several significant disadvantages to taxation at the time of vesting. The first is that, because the fair market value of the Shares may be higher at the time of vesting than at the time of transfer, the taxpayer’s income tax liability may be greater if it is determined at the time of vesting rather than the time of transfer. Additional social security and employment taxes may also be incurred. Furthermore, the income tax paid at the time of vesting on any appreciation in the value of the Shares is computed at ordinary income rates, rather than capital gain rates (which may be lower), and the holding period for the Shares for purposes of determining whether income from their sale qualifies as long-term capital gain will not begin until the Shares have vested. A final disadvantage is that, because the Company is not a publicly held corporation, the Shares are illiquid and (except in certain limited circumstances) may not be able to be sold to pay the U.S. federal income tax.
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TO BE EFFECTIVE, THE 83(b) ELECTION FORM MUST BE FILED WITH THE INTERNAL REVENUE SERVICE WITHIN THIRTY (30) DAYS AFTER THE PURCHASE OF THE SHARES.
Please note that the determination of the fair market value of the Shares should be made in consultation with the Company and the taxpayer’s tax advisor. The fair market value which the taxpayer indicates on the Section 83(b) Election form must be as of the date of transfer, usually the date the taxpayer purchased the shares.
This Client Advisory is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding United States federal income tax penalties that may be imposed on the taxpayer. The foregoing notice is intended to satisfy the requirements for written tax advice under Section 10.35 of Internal Revenue Service Circular 230.
If you have any questions about 83(b) elections, purchase or sale of restricted stock, or general corporate legal matters, please contact Tom Herman at 617 228-4400 or firstname.lastname@example.org