To 83(b) or not to 83(b)
To 83(b) or not to 83(b)
Making an 83(b) election can have a significant effect on the timing and amount of taxes you have to pay on the lapse of vesting restrictions. The Internal Revenue Code generally requires consultants or employees that receive shares of restricted stock to report income as the stock vests, even if they’ve paid full price for the shares at the time of receipt. The same holds true for founders who add vesting restrictions on already owned shares. Accordingly, any increase in stock value beyond the original purchase price is not only recognized at vesting, but also is taxed at ordinary income rates. Section 83(b) of the Code, however, allows founders (or employees, consultants or anyone else who receives shares subject to vesting requirements) to elect to be taxed on the excess of the value of stock over the purchase price at the time of grant or purchase (or, in the case of founders adding retroactive vesting restrictions, at the time of such imposition) rather than at the time of vesting. In addition, by making the election the holder starts the ticking of the one-year capital gain holding period, often resulting in capital gain treatment rather than ordinary income treatment upon sale of the shares. One big condition, however is you have to act quickly - the election must be made within 30 days after you purchase or receive the stock (or impose the vesting restrictions).
To use a concrete example, assume you’re a founder who paid $0.0001 per share when the founders’ shares were issued. You receive your investment, the company starts getting some traction and, at the time of the one year cliff, your founders’ shares are worth $0.20 per share. If you haven’t timely made an 83(b) election, you would recognize income of (and be required to pay ordinary taxes on) $0.1999 per share, even though you’ve not received any cash for your shares and likely are precluded from the provisions of the investment agreements from selling them to realize any cash. And, as the remaining stock vests each month, you recognize income equal to the difference between the fair market value as of the date of each monthly vesting and $0.0001/share. If, however, you’ve made an 83(b) election, then you don’t recognize any income as the stock vests, as the 83(b) election accelerates the timing of recognition of income to the purchase date (or date of imposition of the vesting restrictions, if later).
So, if you’re an employee or consultant who paid full price for your restricted shares, or a founder who purchased founders’ shares at fair market value which has not changed significantly before the imposition of the vesting restrictions, the answer is a no-brainer – make the 83(b) election. Because the purchase price of the shares and their fair market value are the same, there is no income recognized as a result of making the election, and no taxes due on subsequent vesting of the shares. What if, however, you’ve received your restricted shares free as full or partial compensation for your services? Or, you acquired your founders’ shares a year or two ago, bootstrapped the company to the point of funding, increased the value of the company, and thus would recognize an increase in the fair market value of your founders’ shares when the vesting is imposed. Do you still make the election? The answer in those circumstances is less clear.
If the stock goes up significantly (think Facebook or Linked-In), then you’ve saved yourself a bundle of tax on phantom income if you’ve made the 83(b) election. If the stock doesn't rise in value after you make the election, however, you've accelerated your tax without receiving any benefit. Even worse is if you forfeit the stock after making the election. In that circumstance, you get no relief from the taxes you paid when you made the election. So, not only are you out your shares, but you’ve paid income taxes on the value of the shares you’ve forfeited.
Thus, to answer the prior question, an 83(b) election should likely be made if the amount of income you have to report is small, you believe your stock’s growth prospects are good and you think the risk of forfeiture is low. If, however, you think there is a high risk of forfeiture or a large tax payment is due at the time of the election or your company’s growth prospects are low or uncertain, you should consider carefully whether the benefits of the election outweigh the pain of the tax payment due as a result of making the election.
One way founders who think their company is a strong candidate for venture capital investment may avoid this conundrum is to implement their own vesting at the time they acquire their founders’ shares. Not only, as noted above, does this make the 83(b) election a no-brainer, but it also likely avoids the later imposition by the VC’s of vesting starting at the time of the investment, as they’ll probably accept your earlier start date. And, adopting a vesting requirement for all founders has an added benefit, if the company has co-founders, of avoiding the problem created where one of them walks away after a year or two because of a disagreement over strategy or for a better offer but keeps his or her full equity piece. You may not be planning on leaving your company, and thus think vesting unnecessary, but would you want your co-founder to leave you high and dry after a year and be able to walk away with all of his or her shares?
If you do decide to make an 83(b) election, in order for it to be effective you must file the election with the IRS either prior to the date of the stock purchase or receipt or within 30 days thereafter. You also need to provide a copy of the election to the company and file another copy with your federal income tax return for the tax year in respect of which the election is made.
The 30 day deadline (and there are no exceptions to this deadline) is determined by counting every day (Saturdays, Sundays and holidays included) from the day after the date of purchase or receipt of the stock until the date the election is filed with the IRS, with the postmark date of the mailing deemed to be the filing date. The election should be filed by mailing a signed election by certified mail, return receipt requested, to the IRS Service Center where you file your individual tax return. It’s also a good idea to have the receipt hand stamped by the post office from which you’ve mailed the election so you have evidence of the mailing date.
There’s no specified form required to make the election, just required information, which includes:
- A statement that you’re making an 83(b) election;
- Your name, address and social security number;
- A description of the property (for example, 200,000 shares of common stock of My Corp, Inc.);
- The date you acquired or received the shares and the taxable year for which you're making the election;
- The nature of the restriction(s) on your shares (for example, "forfeit 100% of the shares if employment terminates before December 31, 2013; forfeit 75% less an additional 2.0833% per month if employment terminates before the end of each subsequent month").
- The fair market value of the shares at the time you received or acquired them. Note that for this purpose you can't use the possibility of a forfeiture to reduce the value.
- The amount, if any, you paid for the shares.
For ease of preparing the required information, a sample form for making the election is here. As always, consult with your tax advisor to determine how a Section 83(b) election applies to your individual circumstances and consult that same advisor or your lawyer to confirm you’ve filled the information in properly.
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