“The wages of sin are death, but by the time taxes are taken out, it’s just sort of a tired feeling.” ― Paula Poundstone
There are various ways employees and freelancers can be paid. Sometimes, particularly when small businesses are concerned, people are not paid by conventional means, like by check, direct deposit or even cash — and we’ll stay away from tipping for now.
Sometimes, people are paid in stock or shares in a company, also known as equity-based compensation.
There was a scene in “The Social Network” that epitomized this scenario. When the owners realized Facebook was taking off, rather than pay some of his key people, Zuckerberg offered them a certain percentage of ownership in the company. Whether or not that actually happened is irrelevant — in this case, life will imitate art.
Say you consulted for a small business earlier this year and set a rate for $100 an hour. After a full week, the company realizes they cannot afford to pay you $4,000 at a time and offers you a certain amount of stock or equity in the company in lieu of a check that is theoretically worth more than what they owe. For argument’s sake, we’ll say 5,000 shares which are being traded at $1 per share. Once the stock is officially transferred, you assume the risks and benefits of an owner.
If you take the offer, that is your income and you must claim that for the IRS, even though it’s not liquid. The feds will determine your tax liability based on the time you were compensated. The standard is that the value of the property received is the income. So the IRS would take the position that you earned $5,000 that week. You’ll pay taxes on it immediately and if the company performs exceptionally, you’ll be subject to more taxes when you cash in.
The 83(b) and How It Can Help
An 83(b) election allows you to reduce that amount into income, which I define as practically anything that comes in. Those characters from “Social Network” would likely have drafted one, because before they were 30 years old they would theoretically have become millionaires and would have wanted to hold on to as much of it as possible.
Also known as 26 U.S.C. § 83(b), this election lets you decide at the start of your vesting agreement to be taxed for the entire amount that will eventually vest at the present value. You can pay all the tax from the outset based on the original value of the stock — 5,000 shares at a supportable price per share — but you have to contact the IRS in writing explaining how you want to proceed.
A sample letter we’d sent to the IRS is here.
Choose Your Type
The IRS lists examples of equity-based compensation, which includes: Stock Transfers, Stock Options, Stock Warrants, Restricted Stock, Restricted Stock Units, Phantom Stock Plans, Stock Appreciation Rights, and other awards whose value is based on the value of specified stock. Keep in mind, you have to file that election with the Internal Revenue Service within a specified period of time otherwise, it will be disregarded.
We may further explore the 83(b) election in future installments. Feel free to contact Brinen & Associates to discuss the best type of compensation plan for you.