For any security to qualify under Section 1202 as Qualified Small Business Stock, the company must first be considered an eligible Qualified Small Business (QSB) meaning:
- It is a domestic C-Corp
- It has less than $50 million in gross assets (when the stock is issued)
- It is an active business in a qualified trade
- Learn more about about the additional requirements to be a Qualified Small Business
The securities themselves must also satisfy certain criteria including:
- They were acquired at original issuance
- They were acquired in exchange for money, other property (not including stock), or as compensation for services provided to such corporation
- They were held for a minimum of five years
For each security type however, when the 5-year holding period begins is determined based on nuances particular to each security type. Depending on the security type the holding period might begin on the purchase date, the exercised date, vesting date, etc.
What is “Restricted Stock”?
Restricted stock, also known as “section 1244 stock” and “letter stock,” includes:
- Unregistered shares of a corporation’s ownership (i.e directors, executives)
- Non-transferable shares that are subject to specific SEC requirements when traded
These types of restricted securities represent stock in the company that are not yet transferable to the person being compensated. Certain conditions, including (not limited to) product-development milestones or financial earning targets, must be met in order for the shares to be transferred to the employee or executive. This type of compensation incentivizes individuals to remain with a company in order to receive this award—vested stock—and is often an alternative employer compensation to stock options for company executives.
Who Usually Obtains “Restricted Stock”?
Restricted stock is usually reserved for directors, executives, officers, and other corporate affiliates. As stated before, many companies use restricted stock to pay their employees, giving the employees some stake in the company.
Taxation of Restricted Stock
The taxation of restricted stock is governed by Section 1244 of the IRC, and is taxed as ordinary income in the year it is vested. However, restricted stockholders will have to pay a capital loss or gain tax determined by the difference found between the price of the stock when it vested and by the price when it was sold. To determine the amount of restricted shares that must be declared as income, the individual must subtract the fair market price of the day the stock is vested by the initial exercise price.
Furthermore, the stockholder may choose to do a Section 83(b) election. This allows the stockholder to subtract the fair market price on the grant date—rather than the vested price—by the initial exercise price when calculating income tax. Although the bill will be lower because the stock “usually” appreciates between the grant date and vested date, the bill will have to be paid sooner if electing to use Section 83(b). There can be a major risk when electing to use a section 83(b) because an employee may choose to leave their company before restricted stock has vested; in which case, the shares will be forfeited and the taxes won’t be refundable.
What Determines When the 5-year Holding Period for Restricted Stock Starts?
An 83b election allows an employee or startup founder to pay taxes on the complete fair market value of the restricted shares at the time of issuance. Through this election you have the opportunity to prepay your tax bill at a lower amount than you will had to if the stock value increases in years ahead. A founder or an employee of a startup who receives restricted stock has 30 days to file an 83b election or forfeit the opportunity to make an election.
As soon as the Section 83(b) election is filed, the QSBS 5-year holding period starts, but if the restricted stockholder should leave the company before the shares are vested, the shares are surrendered, and any taxes previously paid are non-refundable.
Learn more about 83b elections and Restricted Stock.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.