Effectively Manage the Timing of Restricted Stock Units (RSU) to Receive Optimal Tax Treatment
Startup culture is booming. You’re on your way to disrupting every industry known to man - but first, make sure you’ve got a handle on your finances. As a founder or early stage employee of a startup, not only do you have to worry about your burgeoning service or product, but you must learn to wade through the world of venture capital as well as understand the tax implications of your company stock.
In essence, the Section 83(b) election is a letter sent to the IRS indicating that you'd like to pay tax on the shares or RSUs you receive on the date the equity is granted to you, not on the date of vesting.
Aside from being able to push back the date of paying tax, this election will allow you to move the tax rate from a less favorable ‘Ordinary Income' to a more favorable (read: lower) ‘Long Term Capital Gains’.
This important election must be done within 30 days of the grant date of the restricted stock.This date is usually the date the board approves the grant - not when you actually receive it.
A Working Example
Please see the following example of why you'd want to file the 83(b) election. Note – we are using round numbers and ignoring state tax obligations for simplicity.
1. You own 50% of the stock (1 million shares) of your startup. It vests over 4 years, or 12.5% per year.
2. You received this stock subject to vesting at $.01, the stock is worth $1 at the end of year 1, and $10 at the end of year 2.
3. 40% Ordinary Tax Rate
4. 20% Capital Gains Tax Rate
5. No State or other Tax
If No election is Made
1. At the end of Year 1 your stock is now worth $125,000 – i.e. 12.5% vested over 1 year and each share is worth $1.
2. Without the 83(b) election, you would have to pay tax on the gain (end year value – cost) at ordinary tax rates.
Tax Calculation: (125,000 – $1,250) = $123,750; $123,750 *40% tax = $49,500 tax bill.
3. At the end of Year 2, your have vested 25% and your stock is worth $2,500,000; you will have to pay tax on the new gain:
Tax Calculation: $2,500,000 – $2500; taking into account the tax paid (49,500) = 999,000 – 49,500 paid = $949,500 tax bill
If the value of the startup continues to increase, you will owe tax in each subsequent year, even though you have no actual dollars to pay this tax with. You simply have shares.
83(b) Election Made
Now - if you file the election (Important - it must be done within 30 days after the grant date of the restricted stock), you would pay tax at the time of grant.
1. Tax Calculation: 500,000 (total shares to vest) * .01 (value) = $5000; 5000 * .4 = $2,000 in tax.
2. The key difference will be at the end of each year - you won’t have to pay tax again until you sell the shares. Unlike the tax bills of $49,000 and $949,500 in the non-election example - no tax bill will be generated simply due to ownership.
3. If you sold the shares at the end of year 2 when they were worth $2.5mm; you would pay tax on the 2.5mm gain, but you would pay tax at the long term capital gains rate of 20% - half of the ordinary income tax rate. Aside from the simple arithmetic, you also aren’t required to pay the tax if you don’t want to sell, so you can hold longer without paying the IRS.
Seems like a home run - does it ever make sense to not file this election?
It would depend on the cost of the restricted stock (.01 in our example). If you receive restricted stock worth a nominal amount, it virtually always makes sense to file one.
However, if your shares were granted at $3 and not .01 – your ordinary income right away would be $1.5mm receiving 500,000 shares of restricted stock.
1. Tax Calculation: 500,000 (total shares to vest) * $3 (value) = $1,500,000. Filing the 83(b) election would immediately create a tremendous tax bill for you of ($1.5mm * .4) = $600,000 on the spot.
Hopefully your $3 RSU award is a steal and your company becomes the next Amazon, but in the unfortunate circumstance that the company becomes the next Pets.com - and in particular if it fails before your stock vests - you’d have been better off without the election.
Bottom line – discuss with your individual tax advisor, but remember that the filing must be made (if at all) within 30 days after the grant date of your restricted stock, as that is an absolute deadline that cannot be cured. And note that the grant date of your restricted stock is usually the date the board approves the grant, even if you don’t receive the restricted stock paperwork until later – so sometimes you need to be super efficient about making this decision and filing the correct paperwork.