Section 83 of the Internal Revenue Code works to delay the tax consequence of a transaction that is subject to a condition until that condition is met. The most common example is when an executive receives a grant of shares that are subject to vesting restrictions that lapse over time. In that case, Section 83 of the Code will delay the tax treatment until the restrictions lapse and the shares are fully “earned.”

Delaying taxes is good, right?

Well, in the case of fast-growing, start-up companies, the delay may result in unexpected and disastrous taxes. If the value of the grant is not determined until after the conditions lapse, our executive will face a large tax bill because, presumably, the value of his fast-growing company will have shot through the roof in the meantime. If, however, the tax treatment were not delayed, the tax that would have been due would be negligible, at most. That’s because the value of the shares at the time of initial grant would have been equal to the nominal price that our executive likely paid for them.

Let me give you an example.

Let’s say that our executive paid $0.01 per share for 400,000 shares of stock that are subject to equal annual vesting over a period of four years. At the end of the first, second, third, and fourth years the shares are worth $1.00, $5.00, $10.00, and $20.00, respectively.

Absent Section 83, our executive would pay no tax at all. After all, he has received no income because the amount he paid for the shares ($0.01) was likely the same as the value of those shares ($0.01) on the date he received them.

But because of Section 83, our executive’s tax treatment is deferred, and at the end of the first year he will be deemed to receive income of $99,000 (the difference between what he paid, $0.01, and what the shares are worth on that date, $1.00, multiplied by the number of shares then freed of restriction). And likewise, in years two, three, and four he will receive income of $499,000, $999,000, and $1,999,000 for the number of shares whose restrictions lapse at the end of the second, third, and fourth years, respectively. And the company will be required to pay FICA taxes, too, with respect to all that income.

Ouch!

What’s an executive to do? Section 83(b) comes to the rescue!

Section 83(b) allows our executive to elect to treat the shares as if there were no conditions subjecting them to divestment. In that case, the taxability of the initial stock grant would be determined as of the date of grant. Our executive then pays income tax of, well, $0.00, because he paid exactly what the shares were worth at that time.

How, and when, is the election made? Well, let’s take that up in my next post.

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