The Importance of an 83(b) Election for Startup Founders
May 2, 2022
What is a Section 83(b) Election?
Section 83 of the U.S. Internal Revenue Code provides for, among other things, how and when a founder or an employee of a company will pay taxes in connection with receipt of equity. Before we jump into the details, to help facilitate this discussion – I offer the following scenario that I’ll reference throughout the article:
- Sarah and Cameron form Widget Co, a Delaware C. Corp. Each is granted 1 million shares of restricted stock, which shares vest over a period of four years, and which issuances represent 100% of the issued and outstanding equity.
- Currently, in light of the fact that the entity was just formed, the entity has minimal value.
We begin with the background; Sarah and Cameron would be responsible to pay tax as the restrictions on transfer lapse, or, in other words, as the equity vests. This creates a few problems that we will discuss below. Section 83(b) allows Sarah and Cameron, to the extent an 83(b) election is made, to pay all taxes owed upon grant, as opposed to over time. Specifically, Section 83(b) permits:
any person who performs services in connection with which property is transferred to elect to include in such person’s gross income for the taxable year in which such property is transferred, the excess of:
(A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over
(B) the amount (if any) paid for such property.
Why Would I Pay Taxes Now Instead of Later?
The overall taxes paid on the restricted stock granted to the startup founder will often be substantially lower if an 83(b) election is taken and all taxes are paid when the stock is received and both the stock and the company have a lower valuation than it (hopefully) will over the period of time in which the restricted stock vests.
If you anticipate the value of the stock granted to increase over the period the stock is held, then taking an 83(b) election would make sense because you would pay the overall compensation income tax (what the grants are taxed as) while the value is low. Furthermore, when the stock becomes vested, there will be no compensation income for the IRS to tax because you have already paid those taxes. Any gains related to post-vesting appreciation would be taxed as capital gains. This is often beneficial because historically capital gains have been taxed at a lower rate than compensation income.
Can You Give Me an Example?
Let’s say a startup founder is issued 1 million shares in the company that vest over five years, with 20% of the shares vesting on each year anniversary of the issuance date. Let’s say these shares are valued at $0.10 on the date of grant, $0.50 on the first anniversary, $1.00 on the second, $2.00 on the third, $3.00 on the fourth, and $4.00 on the fifth anniversary. If the recipient timely files (discussed further below) a Section 83(b) election, then the fair market value of the 1 million shares at the time of grant is $100,000, and that amount will be treated as compensation income at the date of grant with taxes being due and paid at that time.
Assuming for our purposes a 35% tax rate at the time, the total income tax paid will be $35,000 ($100,000 multiplied by 35%, or 0.35) if a Section 83(b) election is made. If no Section 83(b) election is made upon grant, the total income tax paid will be $735,000. This is because, in the absence of a Section 83(b) filing, the shares will be taxable as income based on their fair market value at the time of vesting. On the first anniversary when 200,000 shares are vested at a value of $0.50 per share, the fair market value will be $100,000 (200,000 multiplied by $0.50) and the income tax payable will be $35,000 ($100,000 multiplied by 35%, or 0.35). On the second anniversary, 200,000 more shares will vest, but now at a value of $1.00 per share, equating to a fair market value of $200,000 (200,000 multiplied by $1.00) and the income tax payable will be $70,000 ($200,000 multiplied by 0.35). This will continue every year until all shares have become vested.
As illustrated with this example, the founder is able to save $700,000 in taxes because of the Section 83(b) election.
Other Benefits of an 83(b) Election
In addition to a lower income tax bill, there are more potential benefits for the founder and company if an 83(b) election is made.
- If an 83(b) election is made, the company must determine the FMV on the date of grant and collect and deposit the withholding taxes based on that value. However, if no 83(b) election is made, the company must determine the share FMV at each vesting date for tax purposes, determine the amount in taxes that must be withheld from such, and then pay both the employee’s and employer’s share of employment taxes in accordance with such value. To collect the employee’s share of the withholding taxes, the company would either need the employee to give the company a check or withhold vested shares with equivalent value and then use the company’s own cash to pay the tax withholdings. Making such an election avoids the administrative burdens of tracking the vesting schedule every year as well as helps avoid tracking, paying, and reporting withholding or employment tax obligations at each vesting date.
- Additionally, since the shares are usually restricted from free trading, the founder will have to pay such taxes out of pocket and will not be able to sell any shares to help cover the tax bill.
- The founder can also avoid the burden of recognizing ordinary income as repurchase or forfeiture restrictions lapse.
- Finally, the election also begins the capital gain holding period, this is appositive because if the shares are held for more than a year you will potentially qualify for lower tax rates; if they are held for more than five years, any such gain may potentially be excludable from taxable income (see Section 1202 of the Tax Code).
Are There Any Other Conditions That Must be Met to Make the Election?
Just one, which is generally met for such unvested restricted stock grants in startups: the property must be subject to a “substantial risk of forfeiture.” Startups commonly issue stock to founders or other employees or consultants conditioned on the founder, employee, or consultant providing services to a company over a period of time or conditioned upon milestones the company must achieve. If such conditions are not met or the milestones not achieved, the startup may have the right to repurchase shares or the shares are forfeited.
If ownership in such shares is “substantially” likely to cease due to forfeiture, then this substantial risk of forfeiture will meet the criteria for tax purposes.
On the other hand, if the milestones are met or passing of time results in services provided for the requisite period, then the restrictions on such stock will lapse.
Are there Reasons I Would Not Make the Election and Instead Pay Taxes as the Stock Vests?
Yes—not everyone makes the election. While it makes sense for most founders to make the 83(b) election for the initial grant of restricted stock, it may make sense not to make the election if you don’t intend on staying with the company for the vesting of the stocks (so you would not want to pay taxes on something you don’t anticipate receiving) or if you anticipate the value of the shares to decrease. Sometimes, an individual will not file because they do not have the cash to pay the taxes at the time of grant.
Note also that the more taxes paid when fling an 83(b) election the greater the risk you bear in the event you forfeit the stock. If you file an 83(b) election and then forfeit the stock, you cannot claim a deduction or credit for the value of the stock lost or the taxes paid as a result of filing the 83(b) election or the forfeiture of the property.
When Do I Have to Decide on the Election and File?
You must file the 83(b) election within 30 days after you receive the restricted stock. The election is mailed to the IRS with a cover letter and does not have to be attached to your federal income tax return.
If you choose not to file an 83(b) election or you don’t file in time, then you will be taxed based on the fair market value of the stock that is subject to such substantial risk of forfeiture when it vests and is no longer subject to the company’s right of forfeiture or right of repurchase.
If you think you missed the 30-day deadline for making an 83(b) election but aren’t sure, you should revisit your grant agreement to see when the restricted stock was actually issued. Let’s say Sarah and Cameron thought they missed the window to make their 83(b) elections but, upon reviewing their grant agreements, they found that their grants were actually conditioned on a timely authorization by Widget Co’s board of directors. They determine that the board’s approval of their grants was not timely, so Sarah and Cameron take the position that the original grant was not properly issued and request a regrant. The proper reissuance of their grants would restart the 30-day clock for purposes of their 83(b) elections, although the valuation of the stocks will now be based on the date of the regrant.
Let’s assume the same facts as above, except that Sarah and Cameron confirm that the board of directors did, in fact, timely approve their grants and all conditions were met. In this case, they have missed the 30-day election deadline and cannot take advantage of the 83(b) election. What happens now? In addition to the greatly increased tax burden on Sarah and Cameron relating to their grants being treated as compensation income as they increase in value and gradually vest, the founders are also placing a heavy administrative burden on their startup. Specifically, Widget Co will now need to monitor and track Sarah and Cameron’s vesting schedules, correctly value the stock each year as it vests, and report the compensation income from the vested shares on the founders’ W-2s each year. Widget Co will also need to deduct the appropriate taxes, including the company’s share, from their compensation and comply with all applicable tax reporting obligations. Noncompliance with these requirements could result in penalties for the company.
Failure to properly file 83(b) elections (or properly document them) can also be a deterrent for prospective investors or acquirers of a startup; they will want to confirm as part of their due diligence that any 83(b) elections have been made properly to avoid the risk of taking on the burdens outlined above.
Anything Else I Should Know?
The election does not need to be filed for shares that are already vested or, in most cases, for stock options.
The election is irrevocable and the burden to prove timely filing is on the filer, so be sure to file by certified USPS mail with return receipt requested or use one of the IRS-approved private delivery services such as FedEx, UPS or DHL and request a proof of recipient’s signature. Keep copies!
In conclusion, most startup founders who receive restricted stock that will vest over time anticipate the value of the stock to increase and anticipate remaining with the company through vesting. That being said, a vast majority of startup founders who receive eligible equity awards should file Section 83(b) elections.