I spend a lot of time with entrepreneurs explaining how restricted stock and Section 83(b) or the tax code work. It was the subject of a prior blog entry. However, it comes up so often and different people absorb the concept in different ways, so I thought it might be worth attacking again in a different way. Restricted stock can have some very material tax benefits when compared with options, especially in the early stages of any venture. So, here is how restricted stock works. I will compare it to options later.

You may want to incent employees by giving them stock. Here is an example. Easy Company decides to incentivize one of its employees by giving her a stake in the company. It then grants to Jane 100,000 shares (assume for the purposes of this example that the shares have a fair market value of $.01 per share). Two things follow. First, Jane owns the stock and, in our example, has no particular incentive to stay of the sort associated with vesting. Second, Jane has income equal to the value of the shares of stock she has been given. In this example she has income of $1,000. Easy Company must report (and withhold taxes for) this income on Jane’s Form W-2  for the year in which she was given the stock, and Jane must pay tax on that income. Now, $1,000 of income does not seem like much, but if the stock had a fair market value of $1.00 per share, Jane would have $100,000 of income on which she would owe tax. If her marginal tax rate is 40%, then she has to pay $40,000 of tax to the feds.

To fix the incentive problem, the company decides to grant the stock subject to the company’s right to buy it back for $.01 per share if Jane ceases to be employed by the company. In this way, Jane has to stay with the company until there is a liquidity event in order to get the benefit of her shares. But, this seems unfair. What if Jane is employed for 3 years then leaves on good terms, and the company is sold six months later? Doesn’t it seem like Jane should get something for her three years? To fix this problem, the company grants the stock subject to the company’s right to buy it back but expressly limits the number of shares subject to this right so that fewer and fewer shares are subject to this right each quarter with the result that at the end of four years of continuous employment, the company cannot by any shares back. As a result of this arrangement, 6,250 shares cease to be subject to the company’s right to buy them back every quarter. If Jane leaves at the end of one year, the company can buy back 75,000 shares and Jane can keep 25,000 shares.

This arrangement is great, except that it creates a new tax problem. Under the tax code, if Jane does not make an 83(b) election (which we will get to shortly), Jane must take the value of the stock she has been granted into income at the time that the company’s right to repurchase it has lapsed. As a result, Jane will have income equal to the fair market value of 6,250 shares each quarter.

So, let’s assume that on the date of the initial grant the per share value of the stock is $.01 but that at the first anniversary of the grant, the company has developed its business and finds an angel investor who pays $.10 per share and furthermore, let’s assume that on the second anniversary the company has further developed its business and finds an angel investor who pays $1.00 per share. As the shares increase in value, the company has increasing amounts of income to report on Jane’s W-2, for which she has to pay taxes. What was once $1,000 of income, could now be much much more. If the company is really successful, Jane will owe more in tax than she can reasonably pay, and at a time when there is no public market for the stock so she can’t sell shares to raise the money to pay the taxes.  (And keep in mind that all of the income we have been talking about to date is taxed as ordinary income, not capital gains.)

Having said all that, the IRS permits Jane to take all the stock into income (even if it is subject to the company’s right to buy it back) in the year in which it is given to her if she makes an 83(b) election. This election involves filing a form with the government and sending a copy to the company. This form must be filed within 30 days of the grant. In our example, Jane would make the election at the time of the stock grant and would recognize $1000 of income, representing all 100,000 multiplied by their then fair market value of $.01 per share. If Jane expects that the value of the stock of Easy Company will rise, then this is a no brainer. She takes the stock value into income and pays the ordinary income tax on the $1000 of income. This way she begins the capital gains holding period and gets capital gains treatment (on any subsequent increase in value) when she eventually sells the stock in a liquidity event.

This is all well and good, but what happens when two years pass and the stock is now worth $1.00 per share and the company wants to make another grant? The same analysis applies, only now there would be $100,000 of income at the time of grant – assuming Jane made an 83(b) election. At this point stock grants no longer look so desirable. As a result, the company should start using stock options, which do not result in taxable income at the time of grant.