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Tax Savings Strategies for Stock Options and Other Equity Compensation

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How Using an 83(b) + QSBS Combo Can Potentially Save You Millions

Stock options and restricted stock can be complex benefits to navigate, especially when it comes to taxes. However, it’s important to understand your potential tax exposure and take steps to manage it whenever possible.

Here we provide an overview of how equity awards are taxed and two strategies that, when used together, have the potential to significantly reduce your tax liabilities.

Taxable events

Stock options and restricted stock each typically face two taxable events.

Stock options

  • Exercise –When exercised, stock options are taxed on the spread between the exercise and strike prices. This is true for nonqualified stock options (NQSOs) and even incentive stock options (ISOs), given potential alternative minimum tax (AMT) addback.
  • Sale –After exercised, the stock is taxable when eventually sold.

Restricted stock

  • Sale – After vesting, the stock is taxable when eventually sold.

83(b) election

IRC Section 83(b) provides employees with an option to pay ordinary income taxes on the total fair market value of options and restricted stock at the time they’re granted rather than when they’re exercised/vested. There are two potential benefits of doing so:

  • It can shift taxation from ordinary income to capital gains – We can generally assume the valuation of an early-stage company will eventually increase, so paying taxes now allows you to shift taxation of income from ordinary taxes to capital gains taxes.

In addition, many early-stage companies are initially valued at pennies on the dollar, so paying taxes on that lower valuation means your tax liabilities may be minimal.

  • It can accelerate the holding period – The second benefit of paying taxes at the time equity awards are granted is that it allows you to start the clock on the five-year holding period required for the Section 1202 QSBS gain exclusion (details below). Also, if you don’t file 83(b) and wait to exercise your options or allow time to vest in restricted stock, the company’s gross assets may grow to more than $50 million at issue, which would disqualify you from taking advantage of QSBS tax benefits.

The biggest risk associated with making an 83(b) election is if you pay taxes as of the grant date and the value of the stock goes down. In this case, you’d have paid more taxes than necessary. However, with many early-stage companies that have the potential to experience significant growth, it makes sense to pay taxes earlier rather than later.

Section 1202 QSBS

This provision of the U.S. tax code allows holders of qualified small business stock (QSBS) to sell the stock and exclude up to $10 million in capital gains. In order to qualify for the exclusion, the stock must meet the following requirements:

  • Be issued by a C Corporation (S Corporation stock doesn’t qualify)
  • Be issued after August 10, 1993
  • The company must have total gross assets of $50 million or less at the time of issuance (before and immediately after)
  • A minimum five-year holding period
  • At least 80% of the corporation’s assets were used in the active conduct of one (or more) qualified trade or business (certain business types are excluded)

It’s important to note that certain states don’t conform to the 1202 exclusion provisions. For instance, if you’re a resident of California, you’ll only be eligible for a federal tax exclusion. Other states/territories that don’t conform to the 1202 exclusion provisions include Alabama, Mississippi, New Jersey, Pennsylvania and Puerto Rico.

83(b) + QSBS combination to maximize tax efficiencies

A good way to potentially maximize the tax efficiency of your equity awards is by combining the 83(b) election with the 1202 QSBS tax exclusion. Following is an example of how these two strategies, when combined, can work in your favor:

  • Within 30 days of the equity grant date, you file a Section 83(b) election for early exercise/vesting.
  • Once the 83(b) is filed, the clock starts on the five-year holding period required for QSBS eligibility.
  • As of the stock grant date, you owe taxes on the current valuation, which likely equals $0, or a very small amount due to the low valuation for early-stage companies. For stock options, exercising immediately at grant may allow a zero spread for income tax purposes.
  • At the stock’s vesting or exercise date, you’re not responsible for paying additional taxes, as you had already filed the 83(b) election for early exercise/vesting.
  • Assuming the stock qualified for the 1202 QSBS exclusion, when you eventually sell the stock, you can exclude up to $10 million from federal capital gains taxes.

For capital gains beyond $10 million, there are methods to stack QSBS through gifting via non-grantor trusts allowing for further gain exclusion. Our legal team can help.

Combining these two strategies can potentially result in significant tax savings. Allowing that tax savings to compound over time has the power to significantly increase your wealth. You may face potential tax consequences if these strategies aren’t properly executed. Further, understanding these concepts during job offer negotiations is crucial, as some employers may not immediately offer the 83(b) election. That’s why it’s important to seek the guidance of a qualified financial professional.

Could you use some help implementing an 83(b)/QSBS combination strategy? Creative Planning is here for you. Our tax advisors work alongside your wealth manager to help ensure your tax planning strategies remain on track. Our teams have experience navigating a wide range of tax and financial challenges, always with a goal of lowering your tax liabilities and helping you achieve your long-term goals.

Schedule a call to learn more.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.


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