How Tax Works – Episode 6: "Equity-based Compensation and 83(b) Elections"

Host: Matthew Foreman, Co-Chair of Falcon Rappaport & Berkman’s Taxation Practice Group
Release Date: August 19, 2024

Episode Overview

In this sixth episode of "How Tax Works," host Matt Foreman unpacks the myriad options available in equity-based compensation for businesses and employees. He focuses on the tax implications, regulatory frameworks, and practical considerations of different forms of equity grants, including stock options (ISOs and NSOs), stock appreciation rights (SARs), phantom stock, restricted stock units (RSUs), restricted stock awards (RSAs), and the critical role of the 83(b) election. This episode lays the groundwork for next week’s discussion on profit interests, diving deep into real-life structuring and strategic considerations for founders, employees, and advisors.

Main Topics & Insights

1. The Rationale for Equity Compensation

• Alignment of Long-Term Interests:
  • Equity compensation is used to align employee interests with company success over the long term.
  • "Employees want to make money right away...what people do is say, well, what if we pay you by giving you ownership in the business? ...the more the business grows, the recipient does best." (06:48)
• Section 61 & 83 Basics:
  • Section 61: Gross income includes all accession to wealth.
  • Section 83: Receipt of property (not just equity) in exchange for services is generally taxable (“sweat equity”).
  • You can’t generally call something a ‘gift’ if it’s compensation for services — must show ‘detached and disinterested generosity’ (reference to Duberstein case) (09:50).

2. Types of Equity Compensation

A. Stock Options

• Compensatory Stock Options vs. Purchased Options:

  • Discussion centers on options granted in exchange for services, not those bought with cash.

• Incentive Stock Options (ISOs):

  • Strict requirements under IRC Section 422.
  • Need a written plan, must be for employees, exercise price not less than FMV at grant.
  • 10-year expiration maximum; non-transferable.
  • Tax: No income at grant or exercise (unless AMT applies); capital gains on sale post-exercise with holding period met.
  • "ISOs are like squares, everything else—trapezoids, rectangles—is a Non-Qualifying Stock Option." (16:08)

• Non-Qualified Stock Options (NSOs/NQSOs):

  • More flexible; grants to employees or contractors.
  • No strict rules on strike price, term, or who can receive them.
  • Tax: At exercise, recipient pays ordinary income tax on FMV minus exercise price; company receives deduction.
  • If strike price is below FMV at grant, immediate ordinary income.
  • Cannot make 83(b) election on options since they’re not property within the meaning of Section 83.
    • "A really important note: If you sell a compensatory option, that is ordinary income, even though the underlying asset is a capital asset" (23:35; citing Treasury Reg. 1.83-1(b)(3)).

B. Stock Appreciation Rights (SARs) & Phantom Stock

• SARs:

  • Grants the right to gain from future appreciation of stock value.
  • Taxed as ordinary income at payout, usually upon a liquidity event like a sale.
  • "Tend to be fairly inefficient because they’re ordinary income at a time when selling the business tends to have a lot of capital gain with it." (25:50)
  • Potential Section 280G 'golden parachute' concerns for C-corporations.

• Phantom Stock:

  • Cash bonus mimicking equity value or appreciation; similar tax treatment to SARs.
  • Formal documentation more common than SARs, but efficiency issues persist—risk of Section 280G applies.

C. Restricted Stock Units (RSUs) and Restricted Stock Awards (RSAs)

• RSUs:

  • Promise to pay future delivery of stock/cash if vesting requirements are met.
  • Generally taxed at vesting, not at grant, and no 83(b) election is possible.

• RSAs:

  • Actual grant of stock subject to vesting (substantial risk of forfeiture must be truly substantial and likely to be enforced).
  • Taxed at vesting unless an 83(b) election is made; if so, taxed at grant value for all shares, which can be advantageous for early-stage equity grants ("83(b) election is wonderful" (32:53)).
  • Example: 100 shares vest at 25 per year; taxed as they vest or upfront if 83(b) is elected.

• The 83(b) Election:

  • Mechanics & Benefits:
    • Allows recipient to recognize income on equity at grant rather than over vesting schedule.
    • Most valuable when equity value is minimal at grant (founders, very early employees).
    • "By making an 83(b) election, you're pretending for tax purposes only...you received the full equity grant on the day of grant, not vesting." (35:28)
  • Risks:
    • If stock value drops below initial value or becomes worthless, recipient may have a capital loss they can't use to offset ordinary income.
    • "You have to think through: am I willing to just kind of punt on this money?" (37:21)
  • Timing:
    • Absolute 30-day deadline post-grant to file; no remedies if missed.
    • "It is a hard and fast rule. And barring another pandemic...there will be no opportunity to extend it." (43:29)
  • Federal and State:
    • States follow Section 83(b) as a rule (44:00).
  • Practicalities:
    • Sometimes employers require 83(b) election upfront to avoid administrative hassle.

D. Outright Equity Grants

• Immediate taxation at FMV as ordinary income; company deduction.
• Payroll taxes apply for both sides (company and employee).
• "Should I make an 83(b) election? ...the answer is, no, you should not...the 83(b) election does absolutely nothing." (41:16)
• Hard to execute in private companies with illiquid shares due to cash requirements for taxes.

Notable Quotes & Memorable Moments

• On the purpose of equity:
  "Why do people grant equity? …the idea is that the more the business grows, the recipient…does best when the business does best." (06:50)

• On ISOs vs. NSOs:
  "There are many rectangles, there are rhombi, there are trapezoids, but only a few squares. The squares are ISOs. Everything else…that's an NSO." (16:13)

• Regarding gifts and compensation:
  "For a gift to be a gift, it has to be due to detached and disinterested generosity. Duberstein is the case on that… if you’re compensating for services, that’s not detached and disinterested generosity." (09:50)

• On the 83(b) election:
  "By making an 83(b) election, you're pretending for tax purposes only, okay?...You're pretending as if you received the full equity grant on day one." (35:29)

• On the timing of 83(b) elections:
  "It is a hard and fast rule. And barring another pandemic…there will be no opportunity to extend it…there's nothing you can do." (43:29)

• On equity as phantom income:
  "It's often referred to as phantom income because you're having income, but you don't have cash. Now it's not a phantom…it's often something real, but people don't see it, you don't do it the same way." (41:03)

Key Timestamps for Major Segments

| Topic | Timestamp | |------------------------------------------------------------|--------------| | Why Equity Compensation? | 06:40–09:40 | | Section 61 & 83 ‘Sweat Equity’ | 09:41–12:20 | | Gifts vs. Compensation (Duberstein Case) | 09:50–12:10 | | Introduction to Stock Options | 12:21–15:30 | | Incentive Stock Options (ISOs) | 15:31–18:55 | | Non-Qualifying Stock Options (NSOs) | 18:56–23:45 | | Sale of Options: Treasury Reg 1.83-1(b)(3) Explanation | 23:35–24:18 | | Stock Appreciation Rights (SARs) | 24:19–26:55 | | Phantom Stock Discussion | 26:56–28:25 | | Restricted Stock Units (RSUs) and Restricted Stock Awards | 28:26–33:25 | | Detailed 83(b) Election Breakdown | 33:26–38:45 | | Risks and Requirements of 83(b) Elections | 38:46–43:30 | | Outright Equity Grants and Phantom Income | 41:02–42:00 | | Administrative and Practical Considerations | 44:01–End |

Episode Tone & Flow

Matt Foreman provides deep technical substance in a conversational, occasionally humorous tone. He intersperses practical observations (“think through: am I willing to just kind of punt on this money?”), lawyerly disclaimers, and concrete examples with references to bar association events and casual asides (“Them’s the breaks”). The aim is to simplify, not dumb-down, complex issues.

Summary Takeaways

• Equity compensation involves complex tax timing and structuring.
  Understanding the interplay between grant and vesting, ordinary versus capital gain, and the mechanics of the 83(b) election is essential for employees and companies alike.
• The 83(b) election is critical for those receiving equity with vesting—especially in startups or early-stage situations where initial value is negligible.
• Deadlines and compliance are strict: Missing key elections can have permanent consequences.
• Employers and employees must actively manage and plan for the tax consequences of all forms of equity compensation.
• Next episode: Profits interests and practical examples.

This summary provides a structured roadmap of the episode for professionals, founders, or anyone wanting to grasp how equity grants and 83(b) elections impact tax obligations and business decisions—without sitting through the whole recording.