Many entrepreneurs are surprised to learn just how complicated and potentially perilous it can be for a company to issue executive compensation in the form of equity incentives or deferred compensation. Similarly, many entrepreneurs and early-stage employees do not realize that, subject to certain exemptions, receipt of stock that does not have a “substantial risk of forfeiture” (in IRS parlance) is subject to ordinary income tax when issued.
So, for instance, if an employee receives vested common stock that theoretically is worth $100,000 as consideration for services rendered or as part of an incentive package, the employee has $100,000 of ordinary income and a significant tax bill.
Now, what about restricted stock that is subject to a vesting schedule and/or a performance schedule, meaning it is subject to a substantial risk of forfeiture? In that case, the recipient of the shares would recognize ordinary income at the point that the equity vests, meaning it is no longer subject to (you guessed it) substantial risk of forfeiture. Alternatively—and this is something that every entrepreneur who wants to receive equity in a business must understand—they can make an 83(b) election to the IRS within 30 days of the equity grant and pay tax on the fair market value of all of the equity, including the unvested portion, at the time of grant, rather than when it vests. This allows the recipient to pay tax on the shares earlier in the company lifecycle, hopefully when they are worth less, rather than later when they are potentially worth more.
Now, what happens when the recipient fails to make the 83(b) election? How does that oversight get fixed? Well, for starters, if you did not know about the rule or neglected to submit an 83(b) election, take solace that you are not the first, and surely will not be the last, who failed to do so. Unfortunately, there are no provisions for rectifying this problem. However, that does not mean that creative lawyering cannot find a solution.
If the failure to file the election is caught early enough, the issuing company might be able to redeem the equity from the recipient for nominal consideration and then re-issue new shares. Upon re-issuance, the recipient could then file the 83(b) within the requisite time period and pay tax on the fair market value of all the shares at the time of issuance. This is not completely without risk, as the passage of time between issuance could result in a valuation change if enough time has passed or if a significant corporate event takes place in the interim, particularly an equity financing. However, that risk can also be mitigated by obtaining an independent 409A valuation, which provides a presumption with the IRS that the valuation of the issued stock is reasonable.
There is also the risk that comes with every 83(b) election, which is that the value of the shares never appreciates—or declines—and the recipient paid tax on the value of shares that flatlined or declined. That is why 83(b) elections make the most sense very early in a company’s lifecycle when the value of tax paid might be fairly nominal, as opposed to mid-cycle or late-cycle when the tax can be quite significant. At that point, stock options or restricted stock units often make the most sense for employee and executive compensation. Either way, make sure to consult with qualified counsel before structuring and receiving employee or executive compensation.