The Internal Revenue Code allows employees, or startup founders, the option to pay an income tax on the total value of the restricted shares (equity) received at the grant date.To effect this taxable event, the recipient of the shares must make an election with the IRS within 30 days of the grant.
Why would any recipient elect to pay taxes, and not defer them?The answer is in the details.Normally, grantees of restricted shares are not taxed until the end of the vesting period.In essence, the shareholder is betting that, at the time of the grant, these shares are at a very low value.Thus, the tax is minimal.And, the assumption is that those shares will be much more valuable in the future.
The shareholder only “loses” if the value of the company continually declines or a liquidation occurs.The IRS does not allow an overpayment claim for worthless stock.If the company value grows during the vesting period, it will not impact the recipient.He has fulfilled his tax obligation.He will not pay any tax as he vests, and gets to keeps his vested shares.If shares are sold in later years, this employee/co-founder is subject to capital gains tax on the proceeds.
The question remains:how does the company justify the valuation of a restricted share?Most professional advisors recommend a thorough, independent valuation, and not the use of book value.Obviously, the further out the growth in cash flow occurs, the less present value in the company.Still, this valuation is subject to IRS scrutiny or audit, so it must be supportable.
We recommend that the initial valuation be updated yearly.First, those with vesting shares will understand how their performance has impacted the firm’s value.Second, later rounds of investors will be encouraged by the firm’s increase in value.