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Welcome to the sixth episode of How Tax Works. I'm Matt Foreman. In this episode I will discuss equity compensation. It will be another two part episode. Sorry, but I'm going to cover stock options, stock appreciation rights, phantom stock, restricted stock and vanilla equity grants as well as 83B elections which kind of pervade throughout. In the seventh episode which will come out in two weeks, I'll give some examples and comparisons and discuss my favorite type of equity grant which is a profit's interest. Probably the most misunderstood one. I think. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law and guidance to demystify how taxes shape the financial and and business choices that we all make. Before I get started, a few administrative Things episodes every two weeks. As has been the case so far, the next episode is going to talk about profits, interests and just general examples. If you have any questions, comments, constructive criticism only constructive, you can email me my FRB email address which you can find via your favorite search engine. A reminder, I think I said this in the last one, but I'm not sure. There is a Tax and Digital Assets Full Day symposium. It's really on fintech but that kind of, you know, with that idea. It's on September 16th. It's at the New York City Bar association, which is technically named, I believe the association for the Bar of the City of New York, but no one calls it that. But I find it funny. There's that kind of full name. There's going to be a link on the webpage with this episode. I have an all Star panel. I'm one of the panelists. I put it together myself as Erica Nahenhaus. She's from Treasury. She's in charge or very very involved with a lot of the regulations, crypto, the broker reporting ones that were released recently. A few other things. We have Roger Brown from Chain Analysis. I'm really excited and Edward so from White and Case is going to moderate the panel. So things should be really good. Hour and a half. It's in person. It will afterward, I don't know how long afterward go and be released into the wild as a webinar that you can download and watch. I know there's cle. My understanding is they also do CPE for accountants and most of the time it also goes for EAs but I'm not sure I know it's New York, but most states also pick up on it. New York is a pretty good reciprocity state for cle and the New York City bar is pretty good. So really excited for that. I don't know the time of my panel yet. That is still TBD or if it's been determined. I don't know it yet. Anyway. So what are we discussing today? We're discussing equity compensation, right? And there's a lot of stuff we're going to talk about. We're going to talk about Section 61 and 83 of the Internal Revenue Code, stock options, ISOs and NSOs, or NQSO's SARs, which is not the SARs that people talk about. Phantom stock, restricted stock units, restricted stock awards and equity grants again, you know, a lot more. 83B kind of throughout. And we're going to talk about profits interests in two weeks, although I'm actually recording it pretty much right after this. So the basic idea of equity compensation is really, really straightforward, right? Why do people grant equity? And the idea is you want to align the long term goals with your employee goals, right? Employees want to make money right away, right? They want to be paid the most, they want bonuses. That's what they're going to want. So what people do is say, well, what if we pay you by giving you ownership in the business? And what that does is it really changes the employee's viewpoint on it. I think correctly so. Right. And the idea is that the more the business grows, right? The recipient of the equity grant, the employee, then partial owner, right. Does best when the business does best, when it grows faster, when it increases in value, when it's more profitable. And this isn't just a closely held business issue or a large public company issue. This is a business issue. Every business works this way. And there's a lot of public companies that issue equity or make it less expensive to purchase equity, etc. So the basic premise is under section 61 and 83, which govern it, 6 section 61 talked about a lot, right? And Glenshaw Glass. Right. Accession to wealth clearly realized. And Section 83 says that the receipt of property in exchange for services is taxable. This is commonly referred to as sweat equity, right? You put in the sweat, you get the equity. It's important that section 83 doesn't actually specifically deal with equity. It deals with any sort of property. So if you're paid in alpaca for, if you're paid in aggression apples, if you're paid in smiles, right? And smiles a little tougher A little tougher. But the idea is that that amount that you receive is taxable. The way that I always characterize the transaction whenever I'm talking to a client or someone who's asking questions, right? Someone at a wedding or something, what I always say is the way that you have to think about it is you're paid $100 just to use a number for your services. Then you take that a hundred dollars and you contribute it back to the company and. And purchase stock. That is how section 83 works. Of course, you know the way that 83 works. Again, you know, the amount that has to be recognized is the fair market value of the property, less any amount paid. So if you get $100 a stock, but you actually gave them $50, not the theoretical transaction where they pay cash and give it back, but Basically you get $100 worth of stock, but you pay 50 as well, and then the amount received that's taxable is $50, 100 minus 50. Right. And that is really the idea. That's the crux. I'm not convinced Section 83 needs to exist. It's one of the sort of quirky times in the tax code. They went really specific where I've always felt that 61 and Glenshaw glass, of course, really kind of COVID it. But, you know, they did it. The most common question I get is, well, what if we call it a gift, right? No is my answer, for the most part. Maybe if it's a family member, right? People give gifts to their siblings, people give gifts to their parents, people give gifts to their children, right? That's common. That's a different fact pattern. There's gift tax returns. You have to deal with it. However, for a gift to be a gift, it has to be due to detached and disinterested generosity. Duberstein is the case on that. I'm not going to give you the citation. You can Google it. And what you have to think there is, well, if you're compensating them for services and the compensation you give them is equity, that's not detached and disinterested generosity. So maybe if it's family, because there's another relationship, but it really can't be an equal amount for the services. It has to be a gift. So that's important. All right, let's move on. So the first one is stock options. I'm talking about here what's called compensatory stock options. So if you just buy stock options with cash, that's another ball game. Totally different tax consequences. Not Talking about that here. The definition of compensatory stock options is basically the ability or choice to buy equity, such as stock or LLC units, whatever. In a business I'm going to use the term equity a lot. I might say stock, I might say LLC units, but the concept sort of exists for all of them. It's really any form of equity. And the sort of second most common one is what's called an incentive stock option. ISO. ISO is how it's prominently done so not just Allen Iverson playing basketball. The more common one, although it's just slightly different or cousins, is a non qualifying stock option, NSO or nqso. I say nso, but it's one of the times where I just think it's easier to say that NQSO. I don't think one is right or wrong. ISOs meet very strict requirements, right? Everything else is an NSO. So if you have an ISO but you make tiny foot fault, congratulations, you have an nso. So I always refer to it as a four sided polygon. There are many rectangles, there are rhombi, there are trapezoids, but only a few squares. The squares are ISOs. Everything else four sided polygon, that's an NSO. ISOs. So you need a written plan. Section 422 of the internal Revenue Code has the rules, but generally if the fair market for one share is $100, right. Then to have no tax upon grant, the strike or exercise price has to be $100 right at the time of grant. You want the exercise price to be equal to the value at the time of the grant. There is no income at grant, there's no income at the exercise unless you're in the amt. Alternative interim tax. I know a lot of the changes in the TCJA kind of made the AMT irrelevant, but if you're in the AMT and you get ISOs, you may get income tax at exercise. The formula is complex. Not going into it here. It could be much longer than we need and I only have about 30 minutes. So we're going to, we're going to go quickly. The basis is your amount paid, your holding period is the date of the exercise, not the date of the grant. And it's long term capital gain. It's called a disqualifying disposition and that could be ordinary income. When I talk about how nsos work, you'll see what's going on. Basically if you trip, if you follow that up, if you sell too early, the ISO becomes an NSO. There are another couple more restrictions. Within ISOs, there is a 10 year period from the date of the grant to when they must expire. If the period is 10 years in a day, congratulations, you have an NSO. NSOs can be forever. So it's different. The ISOs are non transferable, cannot be transferred and they're for employees only, not contractors. Right. NSOs can be contractors and if you leave the company, you have three months to make the decision whether you're going to exercise or not. They accelerate investing. So it's a really important question. The strike price cannot, cannot be less than the fair market value upon grant. Again, if it is, you have an nso. And that's another issue. Right. So now we're going to talk about nsos, right? Because the definition of an NSO again is really in the negative. What is not an ISO. And for an NSO you basically have to treat as a disqualifying distribution for an ISO. So you can have the strike price that's less than fair market value at grant. And what's really interesting is for nsos, upon exercise, what happens? Okay, so let's go through this. I'll just work through some numbers on the fly. I don't have the numbers in front of me, so it might take a moment. But basically, let's say the price at the value of one share at the date of the grant, okay, is $100. Three years later, it's exercised when the value is worth $125. So you exercise the option, you pay $100, okay, you have received $25 of value because that's a fair market value in excess of what you paid for it, 125 minus 100. So there's $25 of income and that's ordinary income. When you do this, the company itself actually gets a deduction for $25, as if they paid you $25 of cash. You use it to buy part of the equity. The company also gets $100. Sometimes they do what's called a cashless exercise, particularly common with public companies. And basically what they do, especially, you know, I live in New York, a lot of tax rates hit 50% when you're up towards the top marginal tax rates. What they do is if you exercise 100 options, they'll just sell 50 of the shares. You don't actually pay any cash, you pay with equity. That's the idea. If you have a strike price that's less than the fair market value at grant, then upon grant you have ordinary income in the amount of that difference. So if the strike price is 50 and the fair market value is 100. When you grant the option, there's immediately $50 worth of taxable income, which is ordinary income and then a deduction for the business. Couple other things. Can't make an 83B election on options. It's not equity. You're not getting property in the same way. So it's just ineligible. And this is a really important note. If you sell a compensatory option so as compensation for services, you receive an ISO or an NSO and you sell them. Now you can't sell ISOs, but you can sell NSOs. What happens is that is ordinary income even though the underlying asset is a capital asset is stock. Okay, I'm going to give a citation for. Because it's really important. Treasury Reg. 1.83 dash 1B3 and that's a really missed point because you will say, oh, just sell the option and that's capital. Because I've held it for four years. The underlying asset is capital. No, if the option is compensatory, then it's compensatory. It pretends as if you exercise the option right, which is ordinary income because it's an NSO and then you sold it right, which is capital gains. But it's probably short term capital gains which is at ordinary income rates. So it doesn't really matter. That's the idea. Moving on. So stock appreciation, right, or sars. Right, sar, sar, whatever you want to call it. The premise for stock appreciation rights is you get more money upon the sale of a business or some other event. You can make the trigger, really whatever you want. I've seen it with capital raises, I've seen it with, with certain other events and other things happening. But the most common one is upon the sale of a business or partial sale, whatever. There's no tax upon the receipt of an S A R. It's really just a deal bonus. It's ordinary income. When you get it, it's cash. They tend to be fairly inefficient because they're ordinary income at a time when you're selling the business. Selling the business tends to have a lot of capital gain with it. And they're still ordinary income, not the most efficient. I'm not a huge fan of them. But they exist for a variety of reasons. They're really. A lot of times what happens is stock appreciation rights are not documented properly. They're just like, you know, look, I told these three employees they're great. They've been with me for 15 years. That they'll get, you know, the equivalent of 2% if I sell. That's the stock appreciation. Right. I always point out with these that it is likely a golden parachute under section 280G to 80Cap G. And I think it's important to look out for that. It only matters if it's an S corp or excuse me, it only matters if it's a C Corp. S will actually get you out of it. One of the few times where being an S is not detrimental and it's important to note it and target it and say what's going on? There's ways you can get around 280 cap G, but it's important to think about. The next point is phantom stock, which is really similar to sar right to receive cash in the future. There's limits on vesting transferability performance goals. It's taxed when the right to receive vests, which is usually upon sale or some other thing. Phantom stock tend to be a more formal version of equity compensation. Again, not a huge fan. Likely run into issues upon section 280G golden parachute issues. So really not a phenomenally big use for them. But they do happen. You know, they're deal bonuses and they're a good idea. They really can be, it's me, a good way to incentivize and you know, we're going back to what I said in the beginning. You know, why does equity exist? What's the basic idea? And, and the goal is to align the business's goals with the employees goals. And this. They do it. They're less efficient, but they do it. The next one, I actually had a somewhat long discussion on a subway ride back from a baseball game with a friend. He's not a tax attorney, but you know, similar ish job, similar clients. And we were talking about restricted stock units, RSUs and restricted stock awards. RSAs. I use the terms interchangeably. They are admittingly imprecise and they are different, but it's how you have to think about it. So an RSU is a right to receive cash or stock equal to the amount of the cash in the future. There are similar restrictions to what you get for phantom stock. There's limits on vesting transferability and they're often linked to performance goals. There generally is no tax at the grant or at vesting. But the key is, you know, when you exercise the RSU right, so there's a capital gain or loss if it increases or decreases after the vesting is the idea. You are not permitted by statute to make an 83B election. Again, I know we haven't discussed 83B elections. I suspect a lot of you know what they are, but it's not permitted. Well, a lot of people talk about when they say RSU is actually mean RSAs, restricted stock awards. And what they are is a grant of equity that vests over time. And this, this, friends, is where the 83B election is. Wonderful. One difference for anyone who knows that reference, right? So the key for an RSA is that there must be a substantial risk of forfeiture. And before I really kind of go into it, you know, the risk must be likely to be enforced. So, you know, don't worry, John's not going to enforce it. It's not a big deal. Well, then there isn't a substantial risk of forfeiture. The risk must also be substantial. It must be significant. It has to be what's called a non lapse restriction. Non lapse are things that will never, ever, ever lapse. You know, if you were to say, yeah, yeah, the grant of equity will vest, you know, when Mars crashes into Jupiter. Right. I guess theoretically that could happen. Not an expert on planets or anything in that area. I just feel like that's fairly unlikely to happen. And if it were to happen, there are really fundamental other issues that probably make your RSAs kind of irrelevant. Right. So a lot of times what it is, and I'll give you my example, which is one I use every time you grant Equity, you grant RSAs to an employee. The employee receives 100 shares, okay, 25 shares per year for four years, right? You granted on 1:1 of year one. And then every December 31st, if they're still employed, if they meet certain metrics for their employment, they get 25%, 25 shares vest. Right. The way that that is taxed, if there is no 83B election, okay, it's taxable upon vesting at the value upon vesting. So 25 shares at however much they're worth, then the company again gets a deduction. That's fine, but you have to do evaluation, often referred TO as A409A. 409A cap A refers to executive compensation. I'm not really going to go into 409A because section 83 really overrides and all of these trigger 83 on purpose. 490 is an absolute beast. It is substantially more complex than what 83 does. And I just recommend that if you're doing this in this area, you know, talk to someone to make sure you don't run afoul of it anyway. So they get a valuation and they say how much it's worth each time. The assumption, of course, you know, the whole idea of the equity grant is the basic premise that by granting it you're aligning and the employee wants it because the value is going to go up. If the value is going to go down though, just take cash and move along. But because the value is going to go up, they're like, this is great. Company's going to grow 10% per year. The value is going to go up 10% per year. Therefore I'll make more money by doing this vests. I'm going to get capital gains I tax at a lower rate. This is wonderful. Right? So this is where the 83B election is actually probably the best. And it's especially good if very, very, very early on. You're an employee. You'll see these people who get equity grants and the business has five kajillion shares and. And they grant four million at a strike price. Right. The value of each share at 0.0001 cents I've seen as low as 0.00001 cents. So four zeros than a one cent per share, which is just a fictional number at this point. Right. I don't even know what that means. By making an A3B election, you're pretending for tax purposes only, okay? And tax purposes only, you are pretending as if you received the full equity grant on day one at the date of the grant, not on the day of investing. So what theoretically happens? It's a lower amount, a lower value, therefore less tax. And that's the idea. You still get the income, you still get the deduction. Especially if you're coming in right at the start. What happens? A lot, you'll see people who start businesses, everyone contributes some money and then they like, well, you know, Jim should get extra equity. He's going to be the CEO, let's grant him some equity. The company's worth zero or close to zero and he makes an 83B election. Right? Jim makes one, which is great. And so all of his equity pretends to vest on day one. And that's the idea, right? Business gets the deduction or it's worth zero. Right. Sometimes they just say it's worth zero. Move on. That's really good. The business gets a deduction and then every increase from there is going to be capital gains or capital loss, I suppose if it goes down. I should note there of course is a risk to making an 83B election and the biggest One is, if it goes down or goes to zero, you get a capital loss, possibly even a long term capital loss. You can't use capital losses to offset ordinary gain, ordinary income, so you don't have the opportunity to offset a lot of income. Most people don't have the ability to create capital gains to offset their capital losses. So as a result, what really has to happen is you have to think through, am I willing to just kind of punt on this money? Right? And that's the idea. And that's, that's really, you know, just the premise. A lot of times when I do RSAs with clients, I require an 83B election so that we don't have to worry about anything dealing with, you know, later valuations and grants, investing and tracking. It's just done on day one. And so you require the 83B as a condition of the grant. You can do that. I've had employees say they don't want to do it, but I kind of shrugged at them and said, well, you know, them's the breaks, right? That's the deal and they take it. It's fine as long as you're reasonable about it. Where RSAs become really problematic and can be a little bit troublesome. I don't know what the right word is, is if you have a company that's worth a lot of money, right? What a lot of companies do again, you know, and I said this before, they'll grant 100, especially for public companies, right? They'll take 50, they'll sell them on your behalf and use that cash to pay the tax that comes in for it, right? That's the idea with rsa. So that, that's one opportunity, that's one option. So you do. For non public companies or companies that don't have that ability to have that kind of cash, it can be a challenge to do RSAs because a lot of employees may not have, you know, $200,000 to pay taxes. So I think it's really important to think through that, think through what the best option is. The final thing I'm really going to talk about is equity grants and we've already kind of discussed it in a lot of elements. So it's ordinary income upon receipt at the fair market value. This is just giving someone a hundred shares, right? Often referred to as phantom income because you're having income but you don't have cash. Now it's not a phantom, although I suppose the Phantom of the Opera, just the term phantom, right? It's often something real, but people don't see it, you don't do it the same way. And this is why we say to them, if you're getting, you know, equity worth a hundred dollars, this is if they gave you $100 and you used it to buy the equity, you still have to pay the tax. Because gave is the wrong word. You didn't give it to you. You compensated you for services. That's the idea of section 83 is the receipt of compensation for services. So you know, the recipient is the grantor, right? Ordinary income at fair market value. There's a deduction for the company, right? There's payroll taxes. Both the recipient and the grantor have to pay payroll taxes on the value that they received. Anything that's ordinary income, you're paying those payroll taxes. That's really important. I get a question of should I make an 83B election? And the answer is, no, you should not make an 83B election because you received it in full. And the 83B election does absolutely nothing. It may just confuse the IRS, although what I've learned is people have made these elections from time to time. I run into it and the IRS just kind of shrugs. I don't know how much they pay attention to it. I should note. And, you know, I think it's really important. 83B elections have to be made within 30 days. It is a hard and fast rule. And barring another pandemic, which I think we can all agree that no one wants, there will be no opportunity to extend it. People are like, whoa, I missed my 83B date. You know, I know you can make a late S election. I know you can do this late. I know you can ask the IRS for, you know, what. What can I do? And my answer is, there's nothing you can do. The A3B election is fully done. 30 days. That's it. If you make one, it is for federal and state purposes as well. Every state follows 83B elections and 83 generally. There's some stuff within 83 that some states may decouple from, but nothing really relevant here. Here. The common fact pattern, you know, like I said, is to do it. Easy to do equity grants if you're a public company. Really, really hard if there is no liquid market. Like I said, you know, I've seen companies that raise capital in order to give loans or give bonuses to employees along with equity grants they gave a year ago that now the taxes have come due. And then there's issues with that with interest for late payment or penalty for under too low of estimated payments, et cetera. Don't recommend that. You know, talk through, think about it. Think about what you're trying to do. And that that's really important. So I. I've spent the last 20 some minutes kind of running through this. I know I've gone pretty quickly, but next episode's going to be a little slower. Equity Grants, Part two. Right. Profits, interests. And we're going to talk about sort of different examples and comparisons between them a little bit, especially comparing them to profits. Interesting. Which really can be the most efficient way to grant equity. So that was the sixth episode of How Tax Works. I hope you learned something. I'll be back in two weeks with the seventh episode and more equity compensation. Profits, interests. And now for the best song of all time.