Rewarding Employees with Incentive Stock Programs (ISOs), specifically addressing the 83(b) Election

While watching a Public Channel documentary detailing the very beginnings of Silicon Valley, circa 1960’s, the most interesting information I gained described the short history of why Robert Noyce et al. left Fairchild Semiconductors – The Noyce team had no long term stake in the success of their inventions in semiconductors and demanded equity from the Company.  When their demand had been brushed aside, they bolted from their employer and founded the current semiconductor leader, Intel. From there, they adopted a policy of rewarding their staff with equity.  That same entrepreneurial spirit also spun off over 100 technology companies with the same policies to employee compensation: combining a base salary with an incentive stock program – now a staple in Silicon Valley. And this compensation program has become a critical tool to retain top managers and new talent in Silicon Valley since the founding of Intel.

There is another historical period that relates to the 83(b) election and prefaces this blog.  During the recent digital era, the Valley suffered a serious recession during the early 2000’s which depressed the underlying stock value of those technology companies.  However, the incentive stock programs moved forward anyway, rewarding the employees with stock – which had a double edged sword from the depressed value — the recipients could not sell them.  Yet they were all hit with high taxable events immediately after vesting.  From there we witnessed the genesis and promulgation of 83 (b).

Note that this blog only discusses 83(b), not any other tax mitigation models for ISOs. Since I work with startup companies, I receive many requests to develop an Incentive Stock Option or Incentive Stock Programs (“ISO”).  Recently, I spent over an hour and half with a founding CEO describing how these programs work in relation to tax.  But an hour and half cannot scratch the surface on how these tax rules operate and where they are integrated in the equity compensation process.

These incentive programs are all influenced by tax treatment. How complex can the tax code be? In my corporate tax course, taught at the best tax program in the country, the law professor spent two weeks describing the intricacies of a single line of the tax code on taxes payable when contributing property or cash to a company upon formation:  What is property? What does immediately thereafter mean? What are the income considerations for contributing property or cash to a new company? What is the adjusted basis?  In other words, one realizes that you must read each word carefully and how these words are normally interpreted by the IRS.

When the ISO program vests, that kicks in gross income treatment through whatever form of ISO program vesting. During my first week of income tax law, the professor introduced the most important part of the IRS Code, Section 61 that defines “gross income” as:

“a) General definition

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;

(2) Gross income derived from business;

(3) Gains derived from dealings in property;

(4) Interest;

(5) Rents;

(6) Royalties;

(7) Dividends;

(8) Alimony and separate maintenance payments;

(9) Annuities;

(10) Income from life insurance and endowment contracts;

(11) Pensions;

(12) Income from discharge of indebtedness;

(13) Distributive share of partnership gross income;

(14) Income in respect of a decedent; and

(15) Income from an interest in an estate or trust.”

Now startup founding executives approach me and ask why do they owe taxes once the company vests stock? They point out that, first, it is just a piece of paper. Second, the stock recipient has not sold those shares to the public markets or cannot dispose of them since the shares have no commercial value, or they are restricted from selling those shares.  Section 61 is clear that the vesting of stock, options, warrants, or units (LLC) must either fall as employment compensation, or, the wild card, “ all income …including, but not limited to….” phrase. In other words, the ISO recipients must declare the gross income from the vesting of that stock.

Does Sec. 61 apply to options? The answer is undeniably yes. An option has value and provides the recipient the right to purchase the underlying stock at a certain strike price. In fact, anyone has the opportunity to buy options in the securities market.  These financial tools have value which represents “gross income” to a recipient. http://www.irs.gov/Help-&-Resources/Tools-&-FAQs/FAQs-for-Individuals/Frequently-Asked-Tax-Questions-&-Answers/Capital-Gains,-Losses,-Sale-of-Home/Stocks-(Options,-Splits,-Traders)/Stocks-(Options,-Splits,-Traders)-5 For example, if a company selects the ISO “options” route, the recipient pays ordinary gross income upon receipt of the option.  Once the option is exercised, the individual needs to hold unto the equity for over a year to apply for capital gains tax (20%) as opposed to the average regular income tax rate of 35%.

Another tax lesson my tax professor taught me that Sec. 61 is the only section of the tax code that defines gross income.  Sec. 61 is short and to the point. The rest of the code, comprising of thousands of clauses and hundreds of sections and pages, only deals with exceptions to Sec. 61.  That is where 83(b) comes to play.

Like many sections in the Code, the reader has to identify the key components for 83(b).  The 83 (b) key prominent phrases are “fair market value”, “property”, “substantial risk of forfeiture”, “amount paid” (or the adjusted basis).  Then one has to consider capital gains against ordinary income within the parameters. Let’s explore what those phrases mean.

The IRS expects the stock recipient to acknowledge the true value of that piece of paper – the “fair market value.”  Since many companies abused the valuation by lowering it way below FMV, the IRS created rule 409 (a) – which established the methodology to determine fair market value.  Essentially, 409(a) takes away the FMV determination by the company and relegates the process to a third party.  Penalty for non-compliance is severe: the employees will be liable immediately, penalized with a premium of 20% plus interest. The requisites are basic: the fair market value (FMV) must be determined using “reasonable application of a reasonable valuation method”; a valuation needs to be performed by qualified firm or individual; and the valuation needs to be updated at least every 12 months, or more frequently if “significant” changes occur in the business between grant dates. http://venturebeat.com/2011/02/03/why-you-should-care-about-409a-valuations/

The key rationale for 409(a) is to determine a commercially reasonable FMV. Recently, I encountered a real example why the IRS applies 409(a).  A CEO informed me that his company’s FMV was practically zero.  I was curious about his remark since the company had $5 million gross revenues the year before with future revenues derived from long term contracts, and has been operational for several years, paying an IT staff numbering over 20.  FMV, in this instance, would be total from the book value and the present value of expected revenues from current contracts. Somewhere along the road, the recipients must prove to the IRS its 409(a) FMV and indicate some gross income. Since he had planned to vest shares under the ISO program by the end of 2013, he wanted to minimize the grantees’ tax exposure by artificially reducing the FMV. Then adjust the options to match the FMV to show zero income for the ISO recipients. A company’s strategy to play that game is dangerous when the IRS has access to the corporate filings as well as its employees. Its data system is well designed to mine and red flag any ISO filing when the FMV is artificially too low. (With an army of supercomputers that data mine discrepancies, the IRS system can red flag the filing. And the system can determine FMV with several financial tools through the company’s previous IRS corporate filings. And compare the current FMV with similar companies.)  IRS will simply loop around, audit the company, and penalize the employees.  It is a precarious venture to challenge the tax agency by disguising 409(a) FMV and such.

After the FMV, then comes the “substantial risk of forfeiture” clause, also known as “restricted stock.”  Restricted stock means that the stock had not been vested without some strings attached. Stock can be granted free and clear – without any strings attached. But then there are no incentives for the recipient-employee to remain with the Company.  He/she can leave just like Robert Noyce departed from Fairchild. As an actual, real life example of the handcuffs that such programs effect, I met a senior programmer whose company had been acquired by Zynga.  The “cliff”, the date the restrictions would be lifted for vesting, took place after one year after the acquisition. Once that cliff arrived, he resigned. (That is why many ISO programs dispense equity over 4 years. One year is too short.)

Restrictions can be drafted in many forms. They can be date related, or can contain some form of clawback. Clawbacks can be a stock grant reversion upon job termination. In any case, the “substantial risk of forfeiture” clause has been broadly interpreted.  To qualify it must be a risk to the shareholder that will force him/her to relinquish his/her shares back to the company upon non-compliance after the ISO grant.

Let’s talk about the next 83(b) phrase, “amount paid” for the warrants or options. If the company received anything but cash, for the IRS to evaluate the income received, the IRS will invariably requires the “adjusted basis” , synonymous with the “amount paid” for the warrant/option (or “property”).  Adjusted basis includes the possibility that, if the amount paid for the warrant/option is a car, as an example – “property” , the product’s value is adjusted by depreciation – hence, the term, adjusted basis. Indeed, every calculation for any “property” as payment in lieu of cash or received in compensation must be adjusted with depreciation.  Stock, however, does not depreciate, but the underlying assets for determining the fair market valuation might have depreciable property that needs to be adjusted to calculate “income” – computers, furniture, cars and so forth.

I have mentioned that 99% of the IRS Code contains many exceptions to reduce “gross income.”  The one applicable exception here is “capital gains”.  Congress, to encourage capitalism, promulgated a rule to encourage shareholders to retain their stock holdings. Hence, if a stock is held over a year, then that stock is subject to 20% tax rate, rather than the average ordinary income tax rate of 35%.

So regardless of whatever route a ISO shareholder takes, he or she will have to pay taxes on “gross income” and apply the “capital gains” rate as early as possible.  That is the basic advantage that 83(b) election offers without waiting for the full calendar holding period. Even if someone is offered an “option”, the yearly cycle does not kick in until the stock vest when the option is exercised.  That means waiting for a year after the stock has finally fallen into the shareholder hands.

A major ISO landmine issue under Sec. 61/83(a) is the “phantom income” tax.  83(b) offers the recipient an exception to phantom income. If the 83(b) election is not exercised, the shareholder will continue to pay taxes yearly if the company’s FMV continues to increase. 409(a) will continue to haunt the option or warrant holder with 61 gross (ordinary) income until a liquidity event. Since 409(a) requires that any company maintaining an ISO program to re-evaluate yearly the FMV that means that the shareholder has to declare additional income to the IRS for the new calendar year whenever the FMV increases. In other words, the shareholder will continue to pay ongoing taxes whether he selects the option strategy or no strategy upon vesting on a continuing basis. Not a pretty situation to be in.  And this program applies even by selecting the option route since it applies to any ISO program.  Under 83(b) the recipient only faces the next tax event upon a liquidity event and that with a capital gains rate.

Meanwhile the 83(b) kicks in the capital gains rate as quickly as possible. It also attempts to reduce the ordinary income tax rate at the very beginning of the vesting.  (Congress drafted 83(b) to encourage entrepreneurship by the adoptions of ISO programs while minimizing tax exposure.) Let’s say the startup company is one year old, with little or no income. The first year cliff kicks in. The FMV will be fairly low or non-existent.  Then the vested stock adjusted basis can be of any value with the result that the shareholder will pay hardly any taxes.  And when the company has traction later on, then the capital gains rate applies, lowering the shareholder’s tax rate substantially. I will repeat myself – whatever ISO program selected, they are all subject to gross income.  What the recipient needs to do is apply capital gains tax as soon as possible through the appropriate ISO program.  Under 83 (b), the least amount of Gross Income can only be derived from the difference between the vested price and the FMV  — the only instance where the capital gains tax does not apply. And the early vesting begins the capital gains clock for the liquidity event (when the company is acquired or does an IPO). So the 83 (b) election has many advantages over other programs.

The problem with 83(b) is explaining the way it functions to the average executive, without delving into the many elements on how the IRS defines the tax technical terminologies. The purpose for this blog is to simplify it for the layman. I hope that this detailed explanation provides the beginning groundwork for ISO program selections.