Stock Awards & Stock Bonuses
I am frequently asked how stock awards are taxed in the context of a private company issuing stock to employees or contractors as a work incentive.
The Taxation of Stock Awards and Stock Bonuses
Here is a short summary:
1) If the stock award is an award of fully vested shares, then the recipient of the award is taxed when he or she receives the shares, based on the value of the shares at that time.
2) If the shares are not vested, the recipient of the award is either:
–taxed on the receipt of the shares based on the value of the shares at the time of receipt, if the recipient makes an 83(b) election; or
–the recipient is taxed when the shares vest, based on the value of the shares when they vest. The trouble with not making the 83(b) election and waiting to be taxed is that when the shares vest they may be worth a lot more than when they were awarded. This can result in the recipient owing more in tax than the recipient can pay.
Here is how Fred Wilson described it:
The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value (which is likely to be the 409a valuation we discussed last week) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes.
This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale.
If the recipient is an employee, then the employer has to withhold income and employment taxes from the employee. This means the employee will have to write a check to the employer upon the taxing of the award.
The taxing of the award can happen either at the time of grant or upon vesting. Therefore, an employer has to have a system in place to enforce the withholding obligation. The employer also has to monitor 83(b) elections.
What If Employee Pays FMV for the Shares?
Sometimes people think that if an employee or service provider has paid fair market value for the shares that somehow the tax problems go away. This is the case if the shares are fully vested upon purchase, and the employee paid fair market value for the shares.
But if the shares are subject to vesting the tax problems are not over. If the employee does not make an 83(b) election within 30 days of receiving the shares, then the employer will have a tax withholding obligation on vesting.
What Should You Do?
Just like Fred said, taxes are the reason most employees wind up with options. Congress could fix this problem. It seems to me that it would be very pro-worker legislation to provide that gross income does not include the receipt of shares in a private company.
Please be aware that this article is a general summary. If you are considering your personal situation, know that your documents may not be standard documents, and the summary above may not accurately apply to your personal situation.