By: Nikolajs Gaikis
Employees working for promising start-ups love stock compensation because a massive payday may be around the corner! Businesses should be aware of the consequences of compensating employees with property. The exciting part is that any business can pay their employees with property!
In this blog, you’ll learn about the tax consequences of compensating employees with property, what deductions are and how to take advantage of them with property compensation, and the pros and cons of compensating employees with property.
Property Compensation for the Employee
Entrepreneurs should understand how employees are taxed under the Internal Revenue Code § 83 when they receive property for their services because the employee’s tax consequences impact your business.
For the employee to determine their tax bill, they must determine the fair market value (“FMV”) of their property compensation. FMV is the price that a motivated buyer and seller would exchange property for on the market. Also, the FMV must reflect any permanent restrictions on it, like a requirement to sell all the property at once.
The most common form of property compensation is stock. Determining the FMV of your company can be incredibly challenging. This topic warrants its own blog post. Thus, this blog will only focus on the tax benefits of property compensation.
Next, employees’ property compensation is taxed when it is substantially vested. Substantially vested means whenever the employee can freely transfer the property and the property is not forfeitable. In other words, if an employee quits and can keep the property, the property is substantially vested because it is forfeitable. If no restriction ever existed, then the employee’s property is substantially vested upon receiving it.
However, employees can elect to pay tax on their property compensation within 30 days of receiving it. Here, they will not pay tax when the property is substantially vested. Instead, the employee pays tax immediately. We’ll call this “the election.” The employee must use the property’s FMV at the time of the election.
Section 83 for the Employer
Let’s get to the fun part where your business saves money! We can skip whether your business has income from an employee’s labor because businesses have no income when receiving services from an employee.
Generally, businesses receive deductions for the costs of compensating employees. Business deductions lower your taxable income. However, paying employees with property could result in two different deduction amounts and times to take that sweet deduction.
If you pay the employee with non-forfeitable property, it is deductible in the year you compensated your employee. Furthermore, the amount of the deduction will be the FMV of the property in the year you paid your employee. Easy!
Paying employees with forfeitable property is more complicated. Here, the employee’s tax choices dictate when your business gets a deduction. If the employee waits until the property is non-forfeitable, your business receives a deduction in the year the property is non-forfeitable. Also, the amount of the deduction is the FMV of the property in the year when the property is non-forfeitable.
If your employee opts for the election, then your business receives its deduction in the year the employee took the election. This will always be within 30 days of compensating your employee with property. Your business deduction will be equal to the FMV at the time of election.
Previously Purchased Property
If your business purchased property and then compensated an employee with that property, your business must determine whether it made a gain or loss on the purchase of that property. You must report that gain or loss to the Internal Revenue Service. Determining a gain or loss is easy.
The magic equation is as follows:
Amount Realized
— Basis
Gain or Loss
The amount realized is the sale price. Here, the amount realized is the FMV of your employee’s services, which always equals the FMV of their property compensation. Remember, the FMV of the property might change depending on whether the employee had the election option and took it. Next, your business’s basis is your cost of buying the property, which includes expenditures like closing costs. Abracadabra! You have determined your gain or loss.
If you have a gain, you must report that as income on your taxes. If you have a loss, your business likely qualifies for a loss deduction. This IRS capital gains and losses guide explains this process well.
The Pros and Cons of Property Compensation
If your business is strapped for cash, compensating employees with property could save you cash, especially if you have the property on hand, like stock. Also, if you compensate your employees with stock, they have a stake in your business and will work as if it was their own. 
Finally, employees may work harder and stay around longer. In fact, with the FTC’s proposed ban of non-competes, substantial vesting may play a role in keeping employees around because they’ll want to keep their property compensation.
A disadvantage of property compensation is that the tax details are more complicated than cash compensation. Also, a major disadvantage, specifically for stock, is losing equity in your company to your employees. This limits your equity in the business or equity that you could use to raise investor capital. Finally, the employee’s election decision determines when your business receives its deduction, if their compensation is forfeitable. If your business really needs that deduction for the current tax year, you should compensate your employees with non-forfeitable property.
The Takeaway for Entrepreneurs
Paying employees with property is an awesome way for them to have a stake in your company. They’ll work harder and stay around longer. It’s also great for ambitious start-ups that are strapped for cash but extremely promising. As with any tax concerns, consulting a professional is always a good idea. Have fun with it, and good luck!
Sources
IRC § 83
IRC § 1001
IRC § 1011
IRC § 1012
https://www.irs.gov/taxtopics/tc703
https://www.pexels.com/photo/graphs-display-on-an-ipad-187041/
https://www.pexels.com/search/employee%20salary/
https://www.pexels.com/photo/tax-documents-on-black-table-6863259/
https://www.pexels.com/photo/black-payment-terminal-2988232/
https://www.pexels.com/photo/positive-senior-man-in-eyeglasses-showing-thumbs-up-and-looking-at-camera-3824771/
I really enjoyed this post! Your title is fantastic and I think that many start-ups would benefit from learning about this topic. You also added a lighthearted tone to a subject that some may find incredibly dry, so great job! My only suggestion would be to take out the sentence that talks about skipping whether the business has income from an employee’s labor, as it might confuse the reader. However, I don’t think that it took away from your overall explanation of the topic. The roadmap at the beginning of the post was especially helpful, the pros and cons section helped the reader better understand the implications of property compensation, and you explained many complicated tax concepts in a very approachable way. Again, great job!!
Good job!
You did a good job of covering all the basics of section 83 and I think your palatable excitement about section 83 transactions makes the reader more interested in what you are saying.
This is an interesting topic and I think most entrepreneurs either don’t realize that there can be unique tax consequences when compensating employees with property, or they haven’t considered using stock or other property as a compensation tool before. This is a good topic for budding and seasoned entrepreneurs alike.
My only suggestions would be:
1) although you did a good job of trying to explain foreign terms on an entrepreneur’s level, some of the commonly used tax terms could probably be replaced with layman’s terms to make it easier for the reader.
2) I noticed a typo near the end of the 6th paragraph. It says “is forfeitable” but it should say “is not forfeitable.”
Again, great job!
Hi Nikolajs-
Great job! As soon as I saw section 83, I knew at that moment I was going to have a nice review from our first tax class with Barker. Lol. I like how you touched upon how the business would be able to deduct based on the employee either taking the election or not. Also, it was good you touched on the 30-day requirement in which the employee would have to either elect to pay the income tax or not. In addition, I liked the last paragraph where you touched on how this could be beneficial for the business keeping cash in their pockets whilst keeping the employee happy by compensating them in a different way. Yes, it could get complicated for tax purposes, but ultimately, I think this could be used by businesses that need capital and are willing to give up some stake in the business. Overall, you did a great job, and I enjoyed the refresher on §83!