In the Previous Article, we explored how Section 83(a) of the Tax Code taxes the receipt of “property” (i.e., equity) by a “service provider” (i.e., the entrepreneur) “in connection with the performance of services” (i.e., working on the business). This can create issues where the entrepreneur contributes his or her idea and a promise to work, an investor contributes money, and both receive equity in the new enterprise.
Section 83(a) operates differently where the entrepreneur’s equity is subject to vesting conditions, also known as a “substantial risk of forfeiture.” Vesting conditions typically come in two flavors: time vesting and performance vesting. Time vesting simply means that the entrepreneur’s equity vests over time pursuant to a specified schedule. The schedule can be “straight line” (i.e., the same amount per year until fully vested), “front-loaded” (i.e., most shares vest at the start of the term), “back-loaded”, subject to a “cliff” (i.e., no shares vest until the end of the term), or anything in between. Performance vesting means that the entrepreneur’s equity vests upon the completion of certain performance based benchmarks. In either case, the entity holds the right to repurchase the entrepreneur’s shares if the vesting conditions are not met.
For example, assume the entrepreneur has 100 shares, half of which are subject to time vesting and half of which are subject performance vesting. The first 50 shares will vest over 5 years in a straight line, i.e., 10 shares per year. The other 50 shares will vest 10 at a time upon reaching 5 distinct benchmarks: income of $1M, $1.5M, $2M, $2.5M and $3M. If the entrepreneur leaves the business before the completion of the five-year vesting period, and/or does not reach the specified benchmarks, the entity can repurchase his/her shares, typically at the lesser of cost or fair market value.
In this example, Section 83(a) postpones taxation of the Entrepreneur’s receipt of the shares because they are subject to vesting conditions. Section 83(a) imposes tax only when the shares are no longer subject to a substantial risk of forfeiture, i.e. they are fully vested. Importantly, Section 83(a) not only imposes tax at this time, but measures the value of the “property” at this time. Thus, in the previous example, the entrepreneur would recognize ordinary income equal to the value of 10 shares each year that vested pursuant to the straight-line schedule. Let’s assume the value of the shares increased 10% every year, starting at $100 per share. In year one, the entrepreneur would have $1100 of ordinary income. In year two, $1210 of ordinary income. In year three, $1310, and so on.
Section 83(b) allows the entrepreneur to elect to recognize the Section 83(a) gain at the time of the original grant. This is known as making an 83(b) election. In the above example, if the entrepreneur made an 83(b) election at the time of grant, he or she would recognize ordinary income of $100,000 immediately. The next article discusses how to minimize or even eliminate this tax liability entirely.