If you’re a startup founder seeking angel investment and venture capital, take the time to understand 83(b) elections – they can save you a lot of money in the long run. While filing an 83(b) election is generally the right move for an early-stage startup founder, it may not always be so; make sure you get advice before moving forward.
A Section 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee or startup founder the option to pay taxes on the total fair market value of the restricted stock (i.e., stock subject to vesting conditions) at the time of the grant.
Startup founders of scalable businesses that are candidates for early-stage investment and who intend to raise multiple rounds of venture capital may have been advised to vest their stock or even had investors insist they vest their founder’s shares as a condition for investing.
When your shares of stock are subject to vesting conditions, despite the shares being issued to and owned by you, they aren’t entirely yours. The shares have restrictions and are subject to forfeiture if you don’t remain long enough (known as time-based vesting) or if you don’t reach certain performance milestones (known as performance-based vesting). Most vesting you’ll see in technology startups is reverse vesting, where the corporation has a right to buy back the unvested shares if the founder leaves early. Vesting is typically four years.
The combination of vesting and the probability of doing financing rounds at ever-higher valuations is the perfect scenario for 83(b) elections, which can make an enormous difference in what you, as a startup founder, keep in your pocket.
What Happens if an 83(b) is not timely filed?
Under the tax rules, unless you timely file an 83(b) election, you will be taxed on restricted stock’s fair market value only when it becomes vested (e.g., no longer subject to the company’s right of repurchase or forfeiture, or in certain cases, if the stock is transferrable without continuing forfeiture conditions). 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 subject to ordinary income tax and applicable income and employment tax withholding.
Suppose you did not pay for your restricted stock, and the value of the shares increases significantly between the grant date and the vesting date. In that case, both the original value and 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 remit the startup’s share of the associated employment taxes. Also, your capital gains holding period, absent a Section 83(b) election, would not begin until vesting.
To the extent that a startup does not do this, then it could be subject to penalties for under-withholding and 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 their 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. Any appreciation in the stock’s value after that 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, at least if you can hold the stock long enough for long term capital gains rates to apply.
Are there situations where filing an 83(b) 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) may not be the best course of action, including the following:
- If you expect the shares’ value to decrease, 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. You would also not receive a tax benefit from the forfeiture of your basis in the forfeited stock.
Additional 83(b) Considerations
Here are a few additional points to keep in mind concerning 83(b) elections:
- An 83(b) must be filed with the IRS within 30 days of receipt of the property – there are no exceptions!
- An 83(b) does not need to be filed for fully vested shares at the time of issuance or stock options.
- 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 and startups. In addition, investors, as part of their due diligence, will want to confirm that 83(b) elections have been filed concerning 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.
Rooney Nimmo has extensive experience working with founders on a variety of issues across the US and cross-border. If you have any questions or need advice on the 83(b) application or other legal matters, please email Allan Rooney, Tim Davis, Elannie Damianos, or Abbey Docherty or call +1 212 545 8022.
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