Katrina L. Berishaj

Restricted stock awards are generally taxed when they vest, which can often occur months or years after such awards are granted. Stock options are generally taxed at exercise after they have vested (for incentive stock options, the spread between strike price and fair market value at exercise is a tax adjustment item for purposes of alternative minimum tax) and at a subsequent disposition. However, in certain instances, an option holder may purchase stock that is not vested. These awards are sometimes referred to as early exercise options. Section 83(b) of the U.S. Internal Revenue Code (IRC) provides taxpayers the ability to elect to pay taxes on the fair market value (FMV) of restricted property at the time the property is granted as opposed to when the property is vested, effectively accelerating the recognition of ordinary income tax. The 83(b) election can be a powerful tax-savings tool, particularly for startup companies, where the value of the stock may be de minimis at the time of grant but is expected to increase over time. Benefits of an 83(b) Election Tax Savings at the Time of Issuance: An 83(b) election allows a taxpayer who is granted an equity award to pay income tax on the award at the time it is granted instead of waiting for the award to vest. Because the FMV of the shares is typically de minimis in a startup’s earliest stages, the taxpayer generally can pay the small amount of applicable taxes (if any) associated with the grant rather than paying taxes on the value of the stock at the time of vesting, when the FMV of the stock is potentially higher. Thus, where the value of stock increases over time, an 83(b) election can result in significant tax savings. Capital Gains Treatment: Filing an 83(b) election starts the taxpayer’s capital gains holding period clock earlier. A taxpayer who makes the 83(b) election will receive the long-term capital gains rate if the sale of the shares occurs more than one year after the date of grant (or exercise date for early exercise options) rather than one year after vesting. Potential Drawbacks of an 83(b) Election One potential drawback of making an 83(b) election is that if the taxpayer later forfeits the shares before the shares vest, the taxpayer is not entitled to a refund for the taxes paid. Thus, there is the potential for a taxpayer to be out of pocket for the amount of taxes paid on stock that the taxpayer never owns. Additionally, if the shares depreciate between the date of grant and the date they vest, a taxpayer who makes an 83(b) election will pay a higher tax by making the election. How to File an 83(b) Election To make a valid 83(b) election, the taxpayer must sign and complete the required election forms and return the forms to the IRS no later than 30 days after the date that the stock award is granted. For restricted stock, the grant date is typically the effective date of the agreement. In the case of early exercise options, it is the date on which the option holder exercises his or her options early (before the options vest). Failure to file within the timeframe will render the election void, and a taxpayer may recognize ordinary taxable income as vesting restrictions lapse. In general, the taxpayer will need to provide the following information on the 83(b) election form: Taxpayer’s general information. A description of the property, including the quantity of shares of the issuer/company. The date of grant. The taxable year for which the election is being made. The nature of restriction or restrictions to which the property is subject. The FMV of the shares of the company on the date granted. The amount, if any, paid for the property. The amount to include in gross income. The taxpayer must file the form with the IRS office that the taxpayer files his or her annual income tax return. A copy of the form should also be provided to the issuer/company. The taxpayer should retain a copy of the completed election form for his or her personal records.

As we explained in a prior blog post – The Basics of Granting Equity-Based Compensation Awards – state laws governing corporate governance provisions typically apply to certain aspects of executive compensation arrangements, including, for example, who has the authority to grant equity awards. In 2022, Delaware amended Sections 152 and 157 of the Delaware General Corporation Law (DGCL) to expand the board of directors’ ability to delegate grantmaking authority with respect to stock rights and options. More recently, on May 16, 2023, and June 30, 2023, the Delaware State Senate and the Delaware State House, respectively, adopted further amendments, which are awaiting the Governor’s signature. If signed into law, the 2023 amendments would become effective on Aug. 1, 2023. 2022 DGCL Amendments Under the amended DGCL § 152 and 157, the board may delegate to any person or body, regardless of whether the delegates are officers or board members, authority to approve issuances of stock, stock rights and stock options. The delegates will be able to determine the recipients of grants, the timing of grants, the exercise price, the number of stock options or rights to be granted, and other terms and conditions of the awards, including vesting and expiration.1 Board resolutions must be adopted, delegating such power to implement the new authority allowed by these amendments. The 2022 DGCL amendments provide that in order for the delegation to a non-board member or body to be proper, the board resolutions must specify the following: The maximum number of stocks, stock rights or stock options that may be granted, and the maximum number of shares issuable upon exercise thereof. A time period during which such stock, stock rights or stock options, and during which the shares issuable upon exercise thereof, may be issued. A minimum amount of consideration (if any) for which such stock, stock rights or stock options may be issued, and a minimum amount of consideration for the shares issuable upon exercise thereof.2 Notwithstanding the limitations of DGCL § 152 and 157 with respect to non-board members and bodies, board committees remain empowered to exercise the full power and authority of the board to make grants of stock, stock rights and stock options. 2023 DGCL Amendments The 2023 Amendments clarify that a corporation’s issuance of stock under Section 153 must meet the minimum consideration requirements (if any) as provided in DGCL § 153. DGCL § 153 was amended to confirm that the minimum consideration requirement (typically any par value) does not apply to the corporation’s disposition of treasury shares. The corporation may also receive cash, any tangible or intangible property, or any benefit to the corporation (or any combination of those) as consideration for treasury stock. DGCL § 157 was amended to (a) clarify that DGCL §157(c) is the exclusive means for the board to delegate authority (b) require the board resolution authorizing delegation to specify a separate time period for the issuance of shares on the exercise of the rights or options, (c) enable the board resolutions to delegate the power to fix the terms on which shares may be acquired from the corporation on the exercise of rights or options and (d) remove the requirement that the board resolution authorizing delegation specify the maximum number of rights or options that may be issued under the resolution. If signed into law by the Governor, these amendments would become effective Aug. 1, 2023. Takeaways As a practical matter, when deciding how much grantmaking authority to delegate to management, it is critical for the board to strike a balance between allowing the expanded flexibility provided by the recent DGCL amendments while ensuring the board retains sufficient control and oversight over the issuance of securities and awards that will dilute the ownership interests of the company’s stockholders. If permitted by state law and the terms of the equity plan, the administrative challenges of granting off-cycle equity awards may be reduced by delegating grantmaking authority to one or more officers. The delegation of grantmaking authority could be especially helpful in instances where companies want to streamline hiring employees or hold on to valued ones without having to go through the time-consuming process of calling a board or committee meeting. On the other hand, prior to the 2022 DGCL amendments, it was the practice in some privately held companies for a CEO (who was also a member of the board) to constitute a one-person board committee for purposes of making equity-based grants. Corporations may continue such practice of delegating the authority to make grants of equity awards to a one-person board committee. Note that the foregoing is more common where the CEO is the founder and still retains significant majority ownership. This is generally not the case in venture capital or private equity-backed companies where institutional investors want control over equity compensation for key employees. As a matter of prudence, boards should consider requiring that delegates provide regular reports of grants made pursuant to delegated authority, as it is important to carefully track and document equity grants made by delegates to ensure compliance with delegated authority and state law, as well as being a matter of good housekeeping. 1 Under prior Delaware law, the scope of an officer’s delegated authority was limited to designating recipients of the awards and/or determining the number of shares issued to each recipient. Delegates generally could not determine vesting requirements or other terms and conditions, which were required to be approved by the board or a committee thereof. 2 The consideration paid for stock rights or options may be set by reference to a formula provided in the board resolution, such as by reference to the trading price of the company’s stock.

Companies are increasingly moving toward performance-based compensation arrangements for their executives.¹ These pay-for-performance arrangements typically apply to equity-based compensation. More broadly, equity-based awards can be a significant component of a company’s compensation program. An equity incentive plan can serve as a powerful tool to attract and retain talent. Whether a startup or a public company, it is imperative that equity awards be properly granted. A few key considerations include: Adopt an Equity Plan. First, it is important for the company’s Board of Directors (Board) to adopt an equity plan. The company should determine what type of plan is appropriate for it, giving consideration to the short-term and long-term intentions of the company. For example, omnibus plans typically provide greater flexibility in the types of awards that can be granted, including incentive stock options (ISOs), non-qualified stock options (NSOs), stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs), performance shares, performance share units, phantom stock and phantom stock units. On the other hand, a more limited plan, like a stock option-only plan, can be more narrowly tailored. Adopt Forms of Award Agreements. Just as a company’s Board should adopt an equity plan, the Board should also approve forms of award agreements. As a practical matter, the Board may want to authorize officers of the company to make grants or to modify or amend the forms to allow grants to be made quickly in connection with new hires or employee promotion, recognition or retention so that there is no need to wait until the next Board or compensation committee meeting for approval of individual grants. The plan (and applicable state law) must allow for such delegation.² In addition, it is prudent for the Board to limit the officers’ authority to modify grants such that any changes to the forms of agreements do not, individually or in the aggregate, have a material financial, legal, tax or accounting impact on the company or any of its affiliates. Grant Awards in Accordance with the Governing Documents. While it’s great to have a plan, it’s even better to follow its terms. The plan must be administered in accordance with its terms, and awards must be granted in accordance with the governing documents. For example, in order to grant a restricted stock award, the equity plan must allow for the grant of restricted stock. Similarly, to permit an optionee to exercise options that have not yet vested, the governing documents must allow for the early exercise of options. Failure to adhere to the governing documents can lead to complex and costly issues. Beware of Tax Implications and Considerations. Each type of equity-based compensation is subject to different tax considerations with respect to both the grantee and the company. It is important to understand the potential tax considerations in connection with each award. For example, the methodology for determining the fair market value of an ISO is subject to Internal Revenue Code (IRC) Sections 421 and 422, but the methodology for determining the fair market value for NSOs and SARs is set forth in IRC Section 409A (409A). The determination of fair market value of restricted stock is subject to IRC Section 83. Under 409A, the value of stock not readily tradable on an established securities market must be determined by the “reasonable application of a reasonable valuation method.”³ The IRS will presume a valuation is correct if an employer uses one of the “safe harbor” methods set forth in the final 409A regulations to determine the stock’s FMV. On the other hand, if an employer does not use a safe harbor method, then the employer will have the burden to prove to the IRS that the exercise price of the stock option is no less than FMV on the date of grant. In general, a reasonable valuation method is one that considers all available information that is material to the value of a company. It is important to note that a 409A valuation generally expires after 12 months if it has not expired earlier due to new information that has a material effect on the value of the company. There are three safe harbor methods for determining FMV under 409A: Qualified independent appraisal method. A valuation that is determined by a qualified independent appraiser as of a date no more than 12 months before the date of grant. Illiquid method for certain startups. The 409A regulations provide a safe harbor for internally-produced valuations of private startups that are younger than ten years old and are not reasonably expected to undergo a change in control within 90 days or a public offering within 180 days of the date the internal valuation report is used. The common stock may not be subject to any put, call or other right or obligation to purchase such stock (other than a right of first refusal upon an offer to purchase by an unrelated third party or obligation that constitutes a “lapse restriction”). The safe harbor requires that a valuation:Be performed by a person whom the corporation reasonably determines to be qualified based on the person’s “significant knowledge, experience, education and training” (generally meaning a person who has at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or other comparable business experience in the relevant industry); be evidenced by a written report; and take into account the value of the company’s tangible and intangible assets, the present value of future cash flows, the market value of similar entities engaged in a substantially similar business and other relevant factors such as control premiums or discounts for lack of marketability. Non-lapse restriction valuation method. Under this method, the use of a valuation formula that, if used as a non-lapse restriction under IRC Section 83, would be considered fair market value for purposes of Section 83 is presumed to be reasonable if the formula is applied consistently to other transfers of shares of the same or substantially similar classes of stock to the issuer or any person who owns stock possessing more than 10% of the total combined voting power of all classes of stock of the issuer. Failure to comply with 409A has hefty consequences. For individual taxpayers: income tax recognition is accelerated to the year of vesting (rather than on the date of exercise); an additional federal 20% excise tax applies; further increases in the intrinsic gain of the stock right continue to be taxed (and excise taxes continue to apply) in future years until the stock right is ultimately exercised or otherwise expires and premium interest and other potential penalties apply to the extent 409A taxes are not timely reported or withheld by the employer. Employers have an obligation to report a 409A violation on Form W-2 or Form 1099 and to withhold on accelerated income (but not FICA). In addition, there may be state tax law consequences. Given these potential consequences, it’s not hard to imagine a scenario where an employee loses all of the value of the equity-based award. Look out for Securities Law Implications. Because equity incentive plans involve issuing securities, companies need to consider applicable federal and state securities laws. There must be an exemption available for all grants. Most companies will rely on Rule 701 of the Securities Act of 1933 when making grants to individual employees pursuant to the company’s equity plan. However, this rule has certain limitations, including exclusions for certain consultants and does not cover non-service providers. Keep in mind that similar limitations are often built into a company’s equity plan (which is intended to incentivize service providers) both for business reasons as well as to ensure the plan is generally compliant with Rule 701. Therefore, certain types of equity grants may not be eligible for issuance pursuant to the plan or may require the applicability of a different exemption. Also, Rule 701 requires a company that issues more than $10 million in equity to employees over a 12-month period to supply Rule 701 disclosures to all employees who might exercise their stock options. Companies may face serious penalties for noncompliance with this requirement. For example, in 2018, the SEC brought an enforcement action against Credit Karma for failure to comply with Rule 701. Companies should also be aware of any state blue sky laws that may apply. ¹ Does performance-based compensation actually improve a CEO’s performance? (yahoo.com) ² For example, the Delaware General Corporation Law permits delegation of authority by the Board subject to certain limitations, including that the resolution authorizing the delegation must fix (a) the maximum number of options or RSUs that may be granted by the delegate, and (b) the maximum number of shares exercisable upon the exercises of the awards granted by the delegate. The Board must also set a time period during which the options or RSUs may be granted and fix the time period during which shares may be issued in respect of the exercise of awards granted by the delegate. See DGCL Section 157(c). ³ Note that the only method that provides protection in the event of a faulty valuation is the independent appraisal, which is discussed herein.