Meaning
Federal tax rules govern the timing and amount of income recognized when property is transferred to an employee or contractor in exchange for services. The section 83a establishes that the fair market value of the property, minus any amount paid, is taxable as ordinary income once it is no longer subject to a substantial risk of forfeiture. It governs the taxation of restricted stock and unvested equity and applies until the rights are fully owned and transferable.
Income Recognition
Taxation occurs at the moment the property becomes substantially vested or transferable. Under section 83a, the difference between the grant price and the value on the vesting date is treated as compensation. This can lead to a large tax bill if the company’s valuation has increased significantly between the grant and the vesting.
The individual must pay this tax using other cash reserves because the shares themselves may not be liquid.
Vesting Schedule
Risks of forfeiture are typically tied to a period of continued employment or the achievement of specific milestones. As long as these conditions remain, section 83a delays the recognition of income. This delay can be a disadvantage if the stock price is expected to rise sharply.
Founders often use a different election to bypass this delay and lock in the tax cost at the start of the arrangement.
Tax Election
Determining the fair market value of private shares requires a formal appraisal to satisfy the authorities. Within the context of section 83a, the price at which the company last raised money or a recent 409A valuation is the benchmark. If the appraisal is too low, the individual may face penalties and interest from the tax office later.
The finality of the tax event occurs only when the shares are either sold or the vesting period is complete.
