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RSA tax strategies

Lesson in Course: Finance at work (advanced, 6min )

Timing is everything. What can an arcade game teach us about tax strategies at a very early stage startup?

Cyclone is an arcade game where a light dashes around a circle. Our objective in this arcade game is to hit a button at just the right time to get the jackpot. If we’re off by a little bit, we still win but we get a lot less. 

With RSAs (restrictive stock award), timing determines the full value of our equity compensation. Knowing the tax implications of when our shares are granted, when we need to file tax elections, and when our shares vest is like hitting the button in Cyclone and winning the jackpot where we pay significantly less in taxes and keep more money in our pockets. Waiting too long could leave us unprepared for a large tax bill. Fortunately for us, filing an 83(b) election with the IRS can greatly help us avoid this situation.

RSAs and the 83(b) election

Without an 83(b) election

When we are granted RSAs from the company, we pay for them outright; however, the shares still need to vest. 

Vesting for RSAs works a little differently than RSUs or stock options. Rather than receiving the shares on the vesting date, we already own them. The vesting schedule reduces the amount the company can buy back from us.

Example RSA vesting
  • We received 1000 shares of RSAs on the grant date
  • These RSAs have a 4 year vesting period with a 1-year cliff
  • 25% would be available to us after the first year
  1. If we leave 6 months into the job, we own 1000 shares of the RSA, but the company can claw back or buy back 100% of our shares at our purchase price. We don't receive anything.
  2. If we leave just after 1 year into the job, we own 1000 shares of the RSA, but the company can claw back 75% (100-25% vested) of the shares. We can walk away with the remaining 25% that was vested.

We pay ordinary income tax on the difference between the stock price when it vests and when we bought it on the grant date. In the example below, the graph breaks down our taxable gain. If we paid $1 for the shares, and the value of the shares ends up below $1, we have a loss and owe no taxes. However, in most cases, the value of the shares increases as the business grows. The difference between the vesting price ($5) and the grant price ($1) is taxed as ordinary income.

Overview of RSAs vs. RSUs 3
This is a payoff diagram from Carta. Read more about them here.
 

When we eventually sell the shares, we’ll owe capital gains tax on the difference between the price of the stock we sell and the value of the shares at vesting. In the example above, that's the area between dark blue and light blue. In this case, we would have paid $4 in income tax and $5 ($10 sale - $5 vesting price) in capital gains tax.

Taxes will be owed the day the shares vest because the IRS recognizes this as ordinary income, regardless of what happens to the share price afterward or what we decide to do with them. If the value of the company grows rapidly, we could be on the hook for a massive tax bill depending on the timing of the grant and our vesting date. Imagine, if the shares are vested at $50 instead of $5! To avoid that situation, we must learn about an 83(b) election.

When vested shares can hurt our wallet

Let’s say we were granted 1,000 RSAs at $1 per share so we have to pay $1,000 for them. The company experienced amazing growth so that when the shares vest, the value of the shares had gone up to $50 per share. 

Our 1,000 shares are now worth $50,000! Our celebration is cut short though because we owe ordinary income taxes on the $49,000 gain. Assuming 30% for income taxes, we will have a $14,700 tax bill. We are in a difficult situation because the “gain” is on paper and the IRS still wants to collect even if we don’t have the cash. To make matters worse, we may not be able to sell the shares to cover the tax bill if the company is still private.

 

Paying upfront with an 83(b) election

Filing an 83(b) simply states that we are going to pay all of our ordinary income taxes upfront.

We can file an 83(b) election which is a notification to the IRS within 30 days of when we are granted RSAs. By doing so, we get the same tax treatment as the early exercising options. Since we already own all of our RSAs, we can tell the IRS that we paid for all of it upfront. This results in zero income tax since there isn’t any gain or difference between the vesting price of the stock and the price we paid for. This means that the only taxes we owe are capital gains taxes when we sell the shares.

Let’s walk through this again. The two-fold benefit of filing an 83(b) is that we won’t have a tax bill when the shares vest and the taxes incurred when we choose to sell will be less, because capital gains tax rates are lower than ordinary income tax rates.

When the 83(b) saves the day

Continuing from the previous example, let’s say that we had decided to file an 83(b) when we were granted our RSAs. The first benefit is that we won’t have to pay any taxes when the shares vest. The second benefit is that the taxes we’d eventually have to pay on that $49,000 gain would be $7,350, regardless if we sell now or later because long-term capital gains tax is only 15%. That’s half of what we’d pay if we didn’t file an 83(b)!

 

Pay attention to when the grant date is, when an 83(b) needs to be made, and when the vesting dates are. Knowing the timing of these will prevent us from being caught off guard by a surprise tax bill and help us maximize the value of our equity compensation. The 30 days to file an 83(b) will go by quickly. Don’t wait to get this information from your employer, talk to a tax advisor, or reach out to us about how to best use these tax-saving strategies.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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