So, you want to give equity in your company to one or more key employees? First, congratulations – you’re a good boss. You recognize the indispensable value of surrounding yourself and your business with quality folks aligned with your mission.
But how do you give equity in your company to these folks, and what are the potential consequences? Well, I’m glad you asked, because this is not something you want to jump into willy-nilly. This process requires precise structuring and a clear shared understanding between employer and employee.
This conversation begins with Section 83 of the Tax Code. In a nutshell, Section 83(a) states that in connection with services rendered, an individual in receipt of property must pay income tax on the fair market value of such property in the year in which the property was received. When the employer grants equity to employees it falls under Section 83(a), as stock in a corporation and units or membership interests in an LLC are considered “property” under Section 83.
Okay, not so bad so far, right? The employer grants equity to the employee, and the employee has to pay income tax on the equity. But wait, there’s more! A common way to structure equity grants is via a vesting schedule, whereby the employee actually owns the equity at the outset but may lose it if the employee leaves the company before the respective vesting date. Example:
- Equity grant date/Tranche 1 vests in 25%: March 1, 2022
- Tranche 2 vests in another 25%: March 1, 2023
- Tranche 3 vests in another 25%: March 1, 2024
- Tranche 4 vests in another 25%: March 1, 2025
In this example, if the employee leaves at any time before March 1, 2024, he or she will lose 50% of the equity.
So, if you implement a vesting schedule, and the employee is to pay taxes on the equity per Section 83(a), taxes are to be paid in the year in which the equity vests, that is, when the employee receives full rights to the equity per the vesting schedule.
And the surprise is that the amount of the tax depends on the value at the time of vesting. I have a feeling you got into your line of work to make money – generate revenue, produce income, and grow your company. Am I right? The amount of income taxes to be paid by the employee on the equity received will correlate directly to the company’s overall valuation as the equity vests. Here is a simple example, continuing with our fact pattern above:
- Year 1: March 1, 2022 Company valuation: $1,000,000
- Year 2: March 1, 2023 Company valuation: $2,000,000
- Year 3: March 1, 2024 Company valuation: $3,000,000
- Year 4: March 1, 2025 Company valuation: $4,000,000
Here, the employee will pay progressively more taxes as the equity vests each year, as the company’s valuation annually increases, thus increasing the value of the equity that is vesting.
This is where Section 83(b) comes into play. Section 83(b) allows the employee to elect to pay all the income taxes on the equity, regardless of a vesting schedule, immediately upon the equity award. The entire taxable amount of the equity is based on the company’s valuation as of the award date. If the company is expected to grow in value, then the employee will be saving a big chunk of change by paying the tax bill at the outset, rather than over time with a progressively growing company and higher taxable amount each year.
Below are a few pros, cons and further considerations regarding an employee’s Section 83(b) election:
- The election must be made by the employee, not the employer.
- The election must be made within 30 days of the award, and there is no late filing, so don’t miss that deadline.
- If the employee makes a Section 83(b) election and pays taxes at the outset but a portion of the equity doesn’t vest, there is no tax refund for the taxes already paid.
- Section 83(b) doesn’t apply to stock options because the option is not actual equity.
- Section 83(b) operates the same whether the equity is given to the employee from the company or directly from an owner.
- If the company has a buy-sell agreement in place among the owners, or if the company’s governing documents otherwise have a formula for determining value of equity interests, that formula should be used in determining value at the time the equity is awarded.
Awarding key employees equity interests in your company demonstrates your commitment to growing your company and to the folks who make your company go. This article has hopefully provided an insight into how this process works and some key considerations to make along the way.
Read More and this article at ColoradoBiz Magazine's website.
*Reposted with ColoradoBiz Magazine permission.