Section 431 Election
This article outlines how to use Section 431 election to understand the value of employment-related shares.
Most individuals are aware that capital gains tax applies to the profit made when selling an asset for more than it was originally purchased for. What is less commonly known is that when you purchase shares in a firm where you work or lead, you may owe income tax not just in the acquisition year but also on a portion of any gains on a future purchase.
It is normal practice to have workers and directors of a corporation sign a section 431 election whenever shares are transferred or granted to them. Employment-related securities are subject to unique tax regulations, and this includes stock subscriptions and acquisitions by staff and board members (whether executive or non-executive). This is an essential aspect of tax preparation for the future.
Do you want to reduce your overall tax burden on employer-issued shares by paying a little extra in taxes now? This article outlines the advantages and disadvantages of employment-related security rules and how to use Section 431 election to understand the value of employment-related shares.
Section 431 Election
Section 431 elections are often requested (or even demanded) of people involved in company transactions that include the sale or issuance of shares to workers or directors. Employment-related securities are subject to unique tax regulations, and this includes stock subscriptions and acquisitions by staff members and directors (both executive and non-executive). The regulations cannot be avoided by distributing the shares to friends and family or other related people, and they apply to all officeholders, including non-executive directors, even if they are not legal workers. Let’s understand more about these employment-related security rules in detail.
Understand Section 431 election or employment-related security rule
The issuance of employment-related securities is subject to a unique set of tax regulations. This includes current and past workers, as well as any directors (whether executive or non-executive) who subscribe for or purchase shares in either their immediate workplace or a firm inside their employer’s group of companies. If an investor is later hired by the firm as a director or employee, they may be affected by the employment-related security rules. They exist to prevent income from shares from being taxed as capital instead of income when their actual income is subject to higher tax rates.
HMRC found that granting staff or directors limited shares lowered their value, allowing them to “convert” income into capital and tax it at lower rates. When the limits, which would normally be outlined in the articles of association or stakeholder/investor contracts, expire or are lifted, the employee is left with a valuable asset that has increased significantly in value. The employment-related security rule specifies that a portion of the capital increase is taxable as income instead of capital gains tax in such instances.
Employees can avoid employment-related security regulation when they sell their shares in the future by making a section 431 election, which allows them to eliminate certain limitations (such as paying for a greater valuation of shares).
How do employment-related shares work?
Shares that you have obtained as a result of your employment are referred to as employment-related shares. These securities were made available to you or another individual by your employer or someone affiliated with your employer in the case that you were allowed to acquire them. The following types of assets are the most frequently offered:
- Ownership shares in an organization formed under the laws of a nation or region other than the United Kingdom (whether or not it is a corporation)
- Financial securities (bonds, debentures, lending shares, etc.).
Employment-related shares are subject to unique tax regulations, and this includes stock subscriptions and acquisitions by staff and board members (both executive and non-executive).
Why do you need a Section 431 election?
The employment-related stocks law mandates that a portion of the capital appreciation be taxed as ordinary income rather than as capital gains. The majority of employment-related assets will have limitations connected to them, the most common of which is the requirement that a director/employee give their shares to the organization or the current owners should they quit the workplace.
As a result, the shares will be considered “employee instruments” under applicable law, and any gain realized upon sale will be taxable as income at a maximum rate of 45% instead of being taxable as capital gains at 10%. This can be avoided by using the purchase price of the shares together with a legitimate Section 431 election.
Benefits and risks of Section 431 election
The Section 431 election is made with the general intent that the shares will be considered to have been purchased at their full, unconstrained market value and that any subsequent appreciation in value will be treated as capital appreciation rather than ordinary revenue.
The valuation of the assets could go down after the decision is made, which could be a negative outcome. However, if the value of the shares is likely to grow, an election is usually advantageous and shields the employing business from future prospective employers’ NIC penalties.
Section 431 elections are not formally lodged with HMRC. Nonetheless, both the person and the employer are required to keep a copy of these elections if HMRC conducts a future tax investigation (a copy might then be requested). If no election under section 431 is made, there is a possibility that HMRC will evaluate the shares using a higher valuation.
How are employment-related securities valued?
Two distinct values may be assigned to employment-related securities once they are issued. The first one, AMV is the value of the shares in the current market condition, with the limits in place. The UMV, on the other hand, is the value of the shares without restrictions and is thus always greater than the AMV. Let’s understand each of them in detail.
- Actual Market Value (AMV) – When an employee or director acquires stock or other assets as part of their employment, the value at which they are obtained is known as the Actual Market Value (AMV). In the free market, the price of the shares would be equal to this value if there were no restrictions or criteria to be met. The AMV is used to compute income or capital gains tax when limitations are lifted or shares are sold. It’s important to keep in mind that the AMV varies from case to case and might be construed in different ways by tax authorities.
- Unrestricted Market Value (UMV) – The value of stocks immediately after a triggering event, without any restrictions or constraints factored in, is known as the Unrestricted Market Value (UMV). That is, it’s the value of the company as determined by the price at which its shares may be bought and sold on the open market. UMV is economically relevant since it helps determine the taxable value of stock options and other equity awards given to workers. To determine the employee’s taxable income, the fair market value of the stock or options is used. Some events, such as an employee receiving shares or options, exercising options, or allowing options to expire, must be notified to the HMRC on the appropriate forms.
The importance of AMV and UMV in Section 431 election
For federal income tax purposes including section 431 election, both the AMV and the Unrestricted Market Value UMV of shares are relevant considerations. Section 431 election permits the elimination of certain limitations connected to shares, which may have major tax impacts for the employee. The employee must pay the shares’ UMV to exercise the section 431 election. After that, they have until the end of the 14th day after receiving the shares to execute the section 431 election.
This document demonstrates that you’ve settled the shares’ UMV and consent to be taxed on them following their value. After making the election, the corporation must notify HMRC by 6 July of the next tax year. Companies may choose to forego sending the official Section 431 paperwork to HMRC and instead maintain it on file for future reference.
Example of employment-related security income tax charge
Let’s imagine that Lucy, one of ABC Inc.’s employees, pays £1 for a share of stock in the firm. The share’s actual market value was influenced by any limitations placed on it. The company’s workers own one class of shares, while investors have the other. All shares have the same voting, income, and release of capital rights, however, Investor Class shares need the approval of Shareholders of the Employee Class to be transferred. Employee shares may be worth less than investor- shares due to this limitation.
Let’s say that on the day of subscription, the employee’s share has a limited market value of £6 due to the transfer restriction.
Therefore, what is the share’s fair market value without any restrictions? Imagine if, on the same day, Lucy acquired her share, an arm’s length buyer purchased investor class shares for £10 each. As employee and investor shares are equal except for the transfer restriction, this represents the unrestricted market value. Let’s see how the taxation works with and without Sec 431 election.
Tax without an election
Here’s how taxes will be calculated without an election:
Taxes paid on purchasing the stock
The employee shareholder is liable for income tax on the £5 difference between the £1 subscription fee and the £6 restricted market value as of the same date.
£5 x 40% = £2 (income tax)
At £4, or 40% of the unconstrained value, the price difference is significant. There will be no tax due on this amount right now.
Taxation upon sale
An income tax of £40 is due on the sale price of the share, or 40% of the total amount received.
At 40% on £40, the income tax is £16.
With a gain on disposal of £94, the capital gains tax base cost is £6 There will be an income tax liability of £40 and a capital gains tax liability of £54.
At 10% of £54, the capital gains tax is £5.40.
If there is no election, the total tax is £23.40 (£2+£16+£5.40).
Tax with an election
If you opt for an election, here’s how the taxes are calculated:
Taxes paid on purchasing the stock
If the employee makes a Section 431 election, she will owe income tax on the £9 difference between the £1 subscription fee and the £10 of the share on the acquisition date.
At 40% of £9, the income tax would be £3.60.
Taxation upon sale
The gain on sale is £90, after accounting for any applicable income tax and the new base cost of £10 for CGT.
At 10% of £90, the Capital Gain Tax would be £9.
With an election, the final tax is £9.60 (£3.60+£9.60)
Need any expert assistance in valuation? Get help from Eqvista
It is difficult to grasp the fair market value standards governing employment-related security. To successfully use a Section 431 election, one must be well-versed in its intricacies. That’s why you must seek the help of professionals when valuing your company. Eqvista’s 409a valuations can help you determine the true market value of your company. Eqvista provides comprehensive client assistance from NACVA-certified valuation experts in addition to personalized company valuation services. If you need assistance with your valuation needs, please contact us right away!