October 28, 2022
Elections for Small Business Stock
Take-Away: Making a timely IRC 83(b) election to be taxed on stock that is awarded to key employees in a start-up corporation will enable a shareholder to meet the requirements of IRC 1202 qualified small business corporation stock and its exemption from capital gains taxes.
Background: In the past we have covered the benefits of qualified small business stock, or QSBS. [IRC 1202.] This Tax Code section allows a shareholder who invests in certain types of ‘start-up’ businesses to exclude up to $10 million in gain, or 10 times his/her tax basis in the corporate stock, provided that the shareholder held onto the stock for at least 5 years. The shareholder must have obtained the stock at its original issuance in exchange for money or property or as compensation for services provided to the corporation. [IRC 1202(c).] No formal election is required to be filed with the IRS in order to qualify as a qualified small business corporation. However, several other conditions also must be satisfied before the shareholder’s stock will meet the qualified small business stock definition, including:
(i) the shareholder must have acquired the shares of stock before the issuing corporation has $50 million of gross aggregate assets; [IRC 1202 (d)]
(ii) for substantially all of the shareholder’s stock holding period, the corporation must use 80% of its assets in a qualified trade or business; [IRC 1202 (c) and (e)]
(iii) the definition of qualified trade or business has its own set of criteria that must be satisfied, including: (a) it must be a C corporation, not an S corporation; (b) no more than 10% of the value of the C corporation can be comprised of real estate or stock and securities [IRC 1202 (e);] and (c) the corporation cannot be engaged in about 20 specific types of businesses, generally in the fields of health, law, financial services, brokerage services, baking, insurance, finance, leasing, investing, etc.
Services as Compensation: The Tax Code provides that if property, like shares of stock, is transferred to an individual in connection with the performance of services by that individual, the fair market value of the property, i.e. the shares of stock, less the amount paid for the shares of stock (if any), is included in the individual’s gross income when the awarded stock is transferable or vests, i.e. the stock is no longer subject to a substantial risk of forfeiture. [IRC 83(a).] The stock received in exchange for services rendered is subject to a ‘substantial risk of forfeiture’ if the individual’s rights in such stock are conditioned on the future performance or nonperformance of substantial services. [Regulation 1.83-3(c).] Accordingly, a shareholder will become fully vested in shares of stock that may have been granted by their employer after any restrictions on transfers of the stock lapse. [Regulation 1.83-(b).] When the stock substantially vests, the Tax Code requires that any increase in the stock’s fair market value between the grant-of-stock date and the stock-vesting date will be treated as wages paid to the shareholder, subject to ordinary income tax rates for the taxable year in which the stock restrictions lapse. [IRC 83(a).]
IRC 83(b) Election: A shareholder may elect to recognize income on the value of the corporation’s restricted stock when it is initially granted, rather than when the stock becomes fully vested. [IRC 83(b).] This election allows the shareholder, such as a corporate founder, executive, or key employee who provides services to the corporation in exchange for the stock, to accelerate the time at which the individual must include the value of the issued stock in his/her taxable income. [Note, the shareholder pays ordinary income tax on the difference between the fair market value of the shares on the grant-of-stock date and the purchase price paid, if any.] Consequently, by making a timely IRC 83(b) election, the shareholder commences his/her holding period and may be subject to tax but at capital gain rates, rather than ordinary income rates, after the shareholder’s right to the shares of stock fully vests and the shareholder subsequently disposes of his/her stock. In short, an election under IRC 83(b) by the shareholder can potentially provide tax savings when the shareholder receives stock in his/her employer that is subject to vesting. If the stock appreciates in value after it is issued to the shareholder, the shareholder will have paid income taxes on a lower value assigned to the stock. Of course, the drawback to an IRC 83(b) election is that if the corporation’s stock at the time of its vesting is less valuable than when it was initially issued, the shareholder will have paid more in income taxes, and he/she will not be eligible for a tax refund or credit.
Example #1: In 2022, Laurel and Hardy form a start-up corporation, Slapstick, Inc., a C corporation that meets the statutory definition of a trade or business, and thus is a qualified small business corporation. Laurel and Hardy issue themselves restricted stock in Slapstick that vests in four annual installments based on their continued employment with Slapstick. Laurel makes a timely IRC 83(b) election with regard to his Slapstick stock; therefore, Laurel reports the current fair market value of his shares of stock in Slapstick to the IRS on his Form 1040 income tax return for 2022 (including the difference between the fair market value of the Slapstick stock on the date-of-grant-of-shares and the purchase price, if any, paid by Laurel as taxable income.) In contrast, Hardy does not file an IRC 83(b) election. Slapstick becomes highly successful over time. Hardy must include in his reported taxable income, subject to ordinary income tax rates, the rapidly increasing value of his Slapstick shares each subsequent year as the shares vest. In contrast, Laurel capped his ordinary income by making a timely IRC 83(b) election; any increase in the value of Laurel’s Slapstick shares will be taxed at capital gains rates, but only when Laurel decides to sell his Slapstick stock in the future. And, it is possible that Laurel will never have to pay any capital gains taxes if Slapstick is a qualified small business corporation.
Example #2: Pretty much the same facts as in #1. Laurel timely makes an IRC 83(b) election and he writes a check for $1,000 to pay for the fair market value of his 1,000 shares of stock in Slapstick, Inc, valued a $1.00 a share. Hardy again fails to make a timely IRC 83(b) election. Because Laurel filed his IRC 83(b) election in 2022, that election begins his QSBS 5-year holding period on the date the Slapstick stock was issued to Laurel. As such, assuming Laurel holds his Slapstick stock into 2027, his 5-year holding requirement for the Slapstick stock will be met in 2027. If Laurel sells all of his stock interest in Slapstick in 2028, he will pay no capital gains taxes, up to $10 million received in sales proceeds. In contrast, Hardy did not timely file an IRC 83(b) election in 2022 when his Slapstick stock was issued to him. Hardy will have four separate tranches of holding periods for QSBS purposes, beginning each year that his Slapstick stock vests, i.e. 25% vests in 2023, 25% vests in 2024, 25% vests in 2025, and 25% vests in 2026. As a result, Hardy’s four tranches of 5-year holding periods for his Slapstick stock for purposes of IRC 1202 will be 2028, 2029, 2030 and 2031. Should Hardy sell all of his Slapstick stock in 2028 like Laurel, then 75% of Hardy’s stock sale in 2028 will be subject to capital gains taxes.
Conclusion: No question, the rules under IRC 83 and IRC 1202 are technical complicated. Yet the exclusion of up to $10 million in capital gains taxes cannot be ignored. For founders of C corporations and early employees of a start-up business who receive restricted stock which may qualify as qualified small business stock, those shareholders should seriously consider timely filing an IRC 83(b) election to kickstart their 5-year holding period under IRC 1202.