Section 83(a) of the Internal Revenue Code states that if "property" is issued "in connection with the performance of services," the difference between the "fair value" of, and the amount paid by the recipient for, the property–usually stock–is taxable to the recipient (and deductible by the corporation) as additional compensation as of the earlier of: (1) the first date forfeiture restraints (if any) lapse, or (2) the first date the property is transferable, value being calculated without regard to restrictions other than those which by their terms never lapse. If an employee is buying stock at a bargain and there are no "substantial" forfeiture risks (other than those which will never lapse) attached, then the impact of §83 is relatively simple–the recipient pays tax on the bargain element upon receipt of the stock.
Section 83 becomes of cardinal importance in venture financings in which employees are acquiring "restricted" stock, meaning stock subject to contractual restraints on transferability and risks of "forfeiture." Despite the fact that restricted stock (in the sense of nonvested stock) can be issued at any time during a corporation's lifetime, the issue is discussed in this chapter, since it routinely arises on corporate organization.
The purpose of vesting restrictions is to tie footloose employees to the corporation with "golden handcuffs." Typically, an employee will be allowed to purchase at bargain prices shares of stock subject to the company's right to buy them back at the employee's nominal cost if the employee prematurely terminates his employment for reasons other than death or disability. Thus, a five-year vesting restriction will typically provide that one-fifth of the shares issued shall vest in each of the five years following the employee's receipt of stock; that is, they are no longer repurchasable by the corporation at cost. The vesting constraint goes hand in hand with an absolute, albeit limited in time, restraint on alienation; the employee cannot dispose of shares to anyone until they are vested. Without that constraint (unless it is clear the forfeiture restriction is binding on transferees, in which case no one would buy at any sensible price), the forfeiture restriction would have little economic bite. If the employee were originally issued 1,000 shares and left of his own accord in the third year following the employee's receipt of stock, the employee would own 400 shares outright and 600 shares would be repurchasable at the employee's cost.
Under §83(a), an employee "lucking" into the opportunity to buy restricted, nonvested stock at a bargain has a problem. He receives a piece of paper he cannot readily sell; and he incurs a contingent liability to pay at some later date tax on the difference between his nominal cost and the artificial "value" of that security, as at a future time. For purposes of computing the tax, such value is calculated as if, contrary to fact, the employee could sell the shares into an auction market, since "investment-letter" restrictions do not count in computing value. Arguably, therefore, the receipt of nonvested stock is no bargain, because when the tax becomes payable (i.e., the forfeiture risk lapses), the stock may be (indeed it is expected to be) highly "valuable" and the tax burdens accordingly aggravated. The potential "Catch-22" is apparent: A owes tax on a $10 stock which he cannot sell–perhaps at any price–and has no way of realizing the cash with which to pay the tax; he pays out of other assets and holds, expecting an IPO which never materializes, and his stock eventually becomes worthless.
The answer to the predicament lies in the provisions of §83(b). As long as value can be measured when the shares are initially issued, the tax problem is not calamitous because the employee is receiving stock at a time when its value, however calculated, is low. Thus, if the early-round cash investors are coming in at $1 per share and the employee is paying 60¢ a share, at least the amount of the tax is calculable: 40¢ times the number of shares sold, times the employee's effective rate of federal tax. (Indeed, if the cash investors buy preferred stock, then the employee may claim no tax is due.) And, the privilege afforded by §83(b) is that the taxpayer may make an election; that is, he may file, within thirty days after the stock has been originally purchased, notice of his choice to pay tax on the difference between the value of the stock received at that time and the amount actually paid for the stock. Once that tax is paid, then vesting restrictions become irrelevant. The stock may go to $100 per share when the employee finally vests with respect to the last share, but no taxable event will occur.
The §83(b) election also changes the nature of the income. If the election is made, then the subsequent tax event occurs upon the sale of stock, and any gain at that time is capital gain. In the absence of the election, the tax event occurs upon vesting and the character upon vesting will be ordinary income. Only the post-vesting appreciation will be capital gain.
It is important to keep in mind that the §83(b) election is available and should be made, even though the employee purchases shares at full value at the time of issuance. It is not, in other words, the fact that the employee is purchasing cheap stock, but that he's purchasing stock subject to a risk of forfeiture, which casts the taxable event out into the future; it's usually true that such stock is cheap stock, otherwise why would anyone agree to the forfeiture restrictions, but such need not always be the case. The virtue of the §83(b) election is that it pulls that event back to the present day, when the gap between the employee's payment and the value of the stock is presumably at its narrowest.
The §83(b) election is not without its risks. If the property declines in value, then the loss would be a capital loss. Under such circumstances and in the absence of the election, the compensatory element would be reduced or disappear. Thus if A receives stock worth $1,000 for free, the §83(b) election results in $1,000 of ordinary income. If the stock declines in value to $400 when A vests and immediately sells the stock, A would have a $600 capital loss. In the absence of the election, A would only have $400 of ordinary income upon vesting.