A Section 83(b) election is a short, generally one-page document you send to the IRS to notify them that you wish to be taxed in connection with property subject to a "substantial risk of forfeiture" (more on this below) that you receive in exchange for services when you receive it, rather than when it vests.
A Section 83(b) election can allow a startup company founder who receives restricted stock to save a substantial amount of taxes because tax is based on the fair market value of the property when it is granted, rather than its fair market value on the date that it vests. By filing the 83(b) election within 30 days after you receive the restricted stock, you can also avoid future tax problems as the risk of forfeiture goes away.
Failing to timely file an 83(b) election can be a nightmare for you and your startup!
What Is a Substantial Risk of Forfeiture?
A risk of forfeiture is a condition that must be met in the future, whether by your performance of services or the achievement of one or more performance milestones, for you to own the property outright. For startups, this commonly occurs when the company issues common stock to founders, advisors, and other service providers that is conditioned on the service provider's agreement to work for a certain period of time or the achievement of certain milestones by the service provider or the company.
If the service provider does not provide services for that time period or the milestones are not achieved, then the startup has the right to repurchase the shares at a discount to fair market value or the shares are forfeited by the service provider.
If it is substantially likely for these types of conditions on ownership to result in forfeiture of the shares, then they will constitute a substantial risk of forfeiture for tax purposes. The satisfaction of these conditions, whether based on the passage of time or achievement of milestones, is frequently referred to as the lapsing of the restrictions.
What Happens If an 83(b) Election Is Not Timely Filed?
Under the tax rules, unless you timely file an 83(b) election, you will be taxed on the fair market value of stock that is subject to a substantial risk of forfeiture only when it becomes vested (e.g., no longer subject to the company's right of repurchase or forfeiture). On the vesting date, the fair market value of the shares that have vested (less the value of any property contributed or cash paid for the shares) will be treated as compensation income and therefore subject to ordinary income tax and applicable income and employment tax withholding.
If you did not pay for your restricted stock and the value of the shares increases significantly between the grant date and the vesting date, then both the original value as well as any increase in value of the shares will be treated as compensation income to you on the vesting date. More specifically, if you are granted restricted stock as an employee of the startup, then the amount of compensation relating to the vested shares for each year is required to be reported on your W-2 for the year, and the startup should withhold taxes on the income and also remit the startup's share of the associated employment taxes.
To the extent that a startup does not do this, then it could be subject to penalties for under-withholding and for improper tax reporting for the affected years. If the shares become fully vested over multiple years and the tax reporting obligations are ignored by the startup and the founder, then it's likely that the only way to fix the problem would be to correct the tax reporting, which would involve the founder re-filing her or his personal tax returns for prior years.
What Is the Benefit of an 83(b) Election?
If you expect your restricted stock to appreciate significantly between the grant date and the vesting date, you may wish to accelerate the tax on the shares and have as much appreciation as possible treated as capital gains, not compensation income. This acceleration can occur if you make an 83(b) election to be taxed at the time of the restricted stock grant, as if no risk of forfeiture existed. Any appreciation in the stock's value after that point will be taxed as capital gain income, which generally means more money to you because capital gain income has traditionally been subject to lower tax rates than compensation income.
For example, let's take a typical situation where a startup founder is issued one million shares that vest over four years, with 25 percent of the shares vesting on the first four anniversaries of the issuance date, in exchange for their services. If an 83(b) election is filed, then the fair market value of all one million shares is treated as compensation income to the founder at the time of grant.
However, if an 83(b) election is not filed, then when the first 250,000 shares vest after one year, the founder would need to recognize as income the full fair market value of those shares as of the vesting date. If the value of the shares have significantly increased in that first year and over the next four years, then the difference in tax can be substantial.
For purposes of this example, let's assume that the shares are valued at $0.05 on the grant date, $0.50 at the end of one year, $1 after two years, $3 after three years, and $4 after the fourth year, and that the founder's ordinary income tax rate is 35 percent.
- If the founder timely makes an 83(b) election, then he or she will pay ordinary income tax on $50,000 ($0.05/share * 1,000,000 shares) at grant, and the total ordinary income tax owed is $17,500 (35% * $50,000).
- If the founder doesn't make an 83(b) election, then he or she will end up paying a whopping $743,750 in ordinary income tax on the receipt of the shares:
Ordinary Income Tax Owed
|After Year 1||$125,000
($0.50 * 250,000 shares)
(35% * 125,000)
|After Year 2||$250,000
($1.00 * 250,000 shares)
(35% * 250,000)
|After Year 3||$750,000
($3.00 * 250,000 shares)
(35% * 750,000)
|After Year 4||$1,000,000
($4.00 * 250,000 shares)
(35% * 1,000,000)
Besides for the potentially significantly higher taxes for the founder, both the founder and the company face administrative burdens if the 83(b) election isn't filed:
- The company must determine the value of the shares as of each vesting date for tax reporting purposes, comply with tax withholding requirements, and pay the employer's share of any employment taxes with respect to such value.
- The founder, as illustrated above, will have to recognize the income and pay tax on any increased value of the shares. If there has been a significant increase in the value of the shares, then the founder may not have sufficient funds to cover the tax bill and, given that the shares are generally restricted, won't be able to sell the shares to generate funds to pay the bill.
A timely 83(b) election avoids these potential nightmares by allowing the founder and startup to ignore vesting for tax purposes. This generally benefits both the founder and the startup because:
- The founder avoids having to recognize ordinary income as repurchase or forfeiture restrictions lapse;
- The startup does not have the administrative burden of having to determine the value of the shares every time more shares vest;
- The startup does not have tax reporting or employment tax obligations with respect to vesting shares; and
- The election starts the capital gain holding period for all shares covered by the 83(b) election.
- This is important because: if you hold the shares for more than a year, then any gain will likely qualify for lower long-term capital gain tax rates; and if you hold the shares for more than five years, then any gain may be excludable from your taxable income under the qualified small business stock rules under Section 1202 of the Tax Code.
Are There Situations Where Filing an 83(b) Election Does Not Make Sense?
Although an 83(b) election generally makes sense for an initial grant of restricted stock to a founder, there are a few situations where filing an 83(b) election may not be the best course of action, including the following:
- If you expect the value of the shares to decrease, then you could wait and recognize the lower value of the shares as they vest. If you had made an 83(b) election, you would have paid more tax than necessary on the shares.
- If you don't expect to stay with the company through any vesting periods or meet the applicable milestones, then there would be no need to pay tax on the value of the shares that you never actually receive.
Additional 83(b) Election Considerations
Here are a few additional points to keep in mind with respect to 83(b) elections:
- An 83(b) election must be filed with the IRS within 30 days of receipt of the property - there are no exceptions!
- An 83(b) election does not need to be filed for (i) shares that are fully vested at the time of issuance or (ii) stock options.
- 83(b) elections should be filed by certified mail with return receipt requested as the burden is on the person filing the election to prove the timely filing of the election.
- An 83(b) election is generally irrevocable once made.
- Please consult with your financial or tax adviser if you have questions regarding how an 83(b) election will impact you.
In a nutshell, timely filing an 83(b) election upon the receipt of restricted stock is strongly recommended for restricted stock grants to founders to avoid future tax complications for founders as well as startups. In addition, investors as part of their due diligence will want to confirm that 83(b) elections have been filed with respect to all stock issued by the company that is subject to a lapsing right of repurchase or forfeiture.
If you are issued stock that is subject to a vesting or some other future action to be taken by you, you can make your life easier by timely filing an 83(b) election!