So you want to give your employees equity in your growing business. But stock options seem so 1999 and phantom stock sounds like a lot of paperwork. What to do?
It’s a relatively straightforward concept in most cases and usually pretty easy (and inexpensive) to put into place. Employees receive common stock in the corporation with some simple but very important fine print attached. Namely, that the employee must stick around for a certain length of time before he or she actually fully owns (or becomes “vested”) in the stock. Coupled with an employment agreement, the award of restricted stock protects the corporation’s downside and offers enough upside to incentivize key employees.
Let’s say your company has two key employees, Mark Z. and Bill G. You give both of them 10 shares of restricted common stock subject to a 3-year vesting period. At the end of 3 years, Mark Z. and Bill G. will each be the proud owners of 10 shares (they will each be “vested”). If either one quits or is fired before the end of 3 years, he loses his stock.
When Mark Z. and Bill G. are granted the restricted stock, they have no income on it. The reason (in tax speak) is that the stock is subject to a “substantial risk of forfeiture”; in other words, they could lose their rights to the stock if they don’t continue to work for the company for 3 years. Mark and Bill will have taxable income on the stock grant when they are vested (after the 3-year period ends).
Mark and Bill can throw this default tax treatment on its head, though, by making an 83(b) election. That’s right. Mark and Bill can actually elect not to wait until their stock is vested to pay the tax. They can pay the tax right now. The advantage to this is that (at least in theory) the stock of the company is going to be worth less now than it will be worth in 3, 5, or 7 years when the stock vests.
So, when Mark and Bill get their stock and the company is still pre-revenue or pre-profit, and the 83(b) election is made, Mark and Bill might be paying tax on a much lower company valuation than where the company might be in 3 years when the stock actually vests.
Of course, there are some risks. Namely, if the stock never vests because Mark and Bill are fired or quit, then they’ve paid tax when they didn’t have to. The stock might also go down in value from the date of grant to the date of vesting. These are risks that must be weighed, but well worth it when thousands of dollars in tax savings is possible.