In the start-up world, founders create a company and hire a business attorney to compile incorporation documents. Once the company is formed, if the founders elect to vest into their ownership over time, the attorney will send the founders a reminder email saying, “Don’t forget to file your 83(b) election! You have 30 days to make this happen.” Then a week later, the founders receive another reminder email, and maybe a few more down the road, but they let the chance to file the election pass on by.
So what is all the fuss about?
The 83(b) election is often forgotten or ignored at the critical moment when a startup begins to gain traction. Or, an employee who obtains a stock vesting agreement for the first time can easily miss it. When used wisely and in the right situation, the 83(b) election can be invaluable.
What is it?
The 83(b) election is available in stock compensation agreements with a substantial risk of forfeiture (a.k.a., restrictions). This is usually seen with stock vesting agreements for founders and executives of newly created companies and does not apply to phantom stock (RSUs, phantom units, etc.). Rather than paying tax each year upon vesting, this election allows you to pay all taxes up front based on the value of the stock at the time of award/grant. Then, when you dispose of your stock years later, you will be subject to capital gains tax rates. (more…)
Every time I meet with a tech executive or founder holding restricted stock, I ask them if they made their 83(b) election. By this point, many have heard the phrase but few can point to an example that is easy to follow. There are both potential risks and rewards in making this choice.
Example of 83(b) Election in an Optimal Situation
You receive a grant of 90,000 restricted shares vesting over three years. The price per share at grant is $0.01. Assume you hold the vested stock and sell at the beginning of Year 5, your marginal income tax rate is 39.6%, your long-term capital gains tax rate is 20%, and net investment income tax rate is 3.8%.
- End of Year 1, the company received angel investment and the value per share is $1.
- End of Year 2, the company picks up steam and the value per share raises to $5.
- End of Year 3, the value per share is $10 and the company prepares to go the venture capital route.
- Beginning of Year 5, the price per share jumps to $20 due to funding valuation.
Without an 83(b) election, you will recognize taxable income each year on the vested portion. The taxable income will be equal to the fair market value less the grant price. Over time, if the value of the stock increases, you will pay more tax at each vesting event.
Restricted Stock Vesting - No 83(b) Election
|Share Price||Taxable Income||Tax Liability
|Total Tax Paid||$504,098
|Grant Date - 12/31/Year 0||$0.01||-||-
|Vesting - 12/31/Year 1||$1||$29,700||$11,761
|Vesting - 12/31/Year 2||$5||$149,700||$59,281
|Vesting - 12/31/Year 3||$10||$299,700||$118,681
|Sale Date - 2/1/Year 5||$20||$1,320,900||$314,374
If you make an 83(b) election, you will accelerate your vesting for tax purposes to the current year and realize income on the current value now.
Restricted Stock Vesting - 83(b) Election
|Share Price||Taxable Income||Tax Liability
|Total Tax Paid||$428,542
|Grant Date - 12/31/Year 0||$0.01||$900||$356
|Vesting - 12/31/Year 1||$1||-||-
|Vesting - 12/31/Year 2||$5||-||-
|Vesting - 12/31/Year 3||$10||-||-
|Sale Date - 2/1/Year 5||$20||$1,799,100||$428,186
This example displays the benefits in an optimal situation. It assumes one income tax rate across multiple years with the sale of stock occurs more than one year after full vesting. Depending on your particular situation, the impact of an 83(b) election may change substantially. Discuss the implications with your tax accountant and/or financial advisor to find out if this option is right for you.
Recently, our Research Team of Dennis Tilley, Rafael Villagran, and Alex Golubev got together with Financial Advisor Mark Metcalf to discuss our TrendWise Investment Program. Many of the program’s details were covered, including the following:
- Harnessing market momentum using objective data
- Rules based trend following
- Limiting subjective interpretation
- Dealing with whipsaw trades
- Small/Value tilt in the program
If you’ve been tuned into financial news lately, you’ve no doubt heard about High-Frequency Trading (HFT). HFT is not new. In fact, it’s been around for over 20 years. Investopedia defines HFT as:
A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
So why is it news now? Last week, a 60 Minutes interview with Michael Lewis suggested that the stock market was “rigged” by high frequency traders. I want to provide my thoughts, as Merriman’s Chief Investment Officer and as a hedge fund manager, on how HFT is affecting Merriman client portfolios. While we will monitor developments over time, the bottom line is that we believe HFT has minimal impact on our client portfolios.
HFT firms are the new market markers in the stock market. Market makers, who’ve been active in markets ever since stock exchanges have existed, act to provide liquidity to stock trading by offering to buy stock at the bid price, and sell stock at a slightly higher ask price. While providing liquidity to the market, market makers have always strived to maximize their profits at the expense of institutional investors and the average person buying and selling stock in their brokerage account.
The transaction cost to investors can be viewed as an expense (paid to market makers) for providing liquidity, and has never and will never impact the fundamental value of the stock market. The cost only comes to bare when buying or selling a stock.
Two forces help protect us from market makers making excessive profits. The first force is the competition among market makers. As with any business, large profits attract competitors. Competition among market makers drives transaction costs lower as they fight amongst each other to provide this service. The battle among market makers is very similar to an ever increasing arms race, where whoever has the best technology wins. Over the last 10 years, computers have replaced the Wall Street traders and NYSE specialists – who in the old days were just as keen to profit from investors.
The second force limiting market maker profits are the countermeasures institutions use to trade large blocks for their clients. Attentive investors should be monitoring their trading and adjusting their investing/trading approach to minimize transaction costs. HFT is just the next story in the everlasting interaction between market makers and institutional investors. While the SEC and other government agencies will eventually catch on to illegal trading activities, the smartest investors generally take a buyer-beware approach to their trading.
In our MarketWise portfolios we take into account the sensitivity to trading costs when selecting investment managers. Dimensional Fund Advisors is obsessive in monitoring their trading costs and minimizing turnover. Their approach is to trade like a market maker by buying and selling stocks with limit orders and they are agnostic about what stocks they buy or sell (as long as a stock fits that fund’s investment approach). This trading approach is much less sensitive to HFT. Stock-picking active managers, and index funds, are typically demanders of liquidity when they trade stocks, which is much more susceptible to exploitation from market markers whether using HFT or via the old specialist system on the NYSE.
In our TrendWise portfolios, we also carefully track our ETF transaction costs to ensure that our approach is as cost -efficient as possible. And finally, individual investors, trading small quantities of stock in their own accounts, have benefited greatly from HFT as bid-ask spreads have narrowed significantly over the last decade or so.
If you have any additional questions about HFT or its impact on your portfolio, please don’t hesitate to speak directly with your advisor.
Merriman does not include a specific allocation to gold in our standard portfolios. This article, by Bryan Harris of Dimensional Fund Advisors, discusses why gold has not been an ideal long-term investment. It includes the following key concepts:
- Gold has done well since the year 2000 and in the 1970s, and can potentially be a safe haven during times of political and economic stress. However, for the entire period of 1971 – 2011 gold performed worse than the S&P 500, U.S. small-cap stocks and non-U.S. stocks on an inflation-adjusted basis.
- From 1980 – 1999, gold experienced a negative return after inflation of -6.5%, vs. strong positive returns for stocks.
- While gold has held its value against long-term inflation, there have been extensive periods when gold did worse than inflation. Gold is also much more volatile than inflation, and can add substantial volatility to a portfolio.
- Unlike stocks, which are productive assets which generate growing levels of income and dividends over time, gold has no cash flow and costs money to own.
For more detail and some illuminating graphs, please see the article.
It seems like every year there’s a slew of tax breaks in danger of expiring. Sometimes Congress extends the tax break, other times they actually expire and fall by the wayside. 2011 is no different, with 3 potentially useful tax breaks on the cutting room table. Those who may be able to benefit from these tax breaks should consider taking advantage of them soon, before it’s too late.
- Sales Tax Deduction – Individuals who itemize their deductions can elect to deduct their sales tax or their state and local income taxes, whichever is greater. There are seven states without a state income tax, so those residents would surely elect the sales tax deduction. Residents of other states may find that they paid very little in state income taxes and may decide to elect the sales tax deduction instead. For those who are taking the sales tax deduction and considering a large purchase, such as a new car, it may be worthwhile to complete the purchase this year in order to maximize this tax benefit while it’s still available.
- Energy Efficiency Credit – Individuals can take a credit of up to $500 for making energy efficient improvements to their homes, including upgrades for roofs, doors, insulation, windows, furnaces, air conditioners, and many others. There are limitations on the amount of eligible credit for the various improvements, and you can find a list of those here. It’s also important to note that unlike many other credits, this one is a lifetime credit–so if you’ve utilized all of the $500 credit in the past, you cannot take any more regardless of your qualified expenditures now. However, if you haven’t benefited from this tax break yet, and are considering making energy efficient improvements to your home, you may want to do so before year end.
- Qualified Charitable Distributions from IRAs – Individuals older than 70 ½ can make tax-free distributions from their IRA to qualified charities. The distribution is not includable in the donor’s income, but it is not deductible as a charitable donation either. This provision primarily benefits individuals who are charitably inclined but don’t have enough deductions to itemize. The qualified charitable distributions will count towards an individual’s required minimum distribution (RMD) for the year, allowing those who don’t need the money from their IRA to donate it without being taxed on it. With year-end fast approaching, individuals who have yet to take their RMD may want to consider this option.
Each of the tax breaks above had been due to expire at some point in the past but was subsequently extended at the last minute. It is possible that Congress will extend these breaks again, but nothing is certain given the deficit and debt problems currently facing our country.
If you think you may benefit from any of these tax breaks, please be sure to consult with your accountant to see how these tax savings may apply to your specific situation.