Why Startup Founders Should File an 83(b) Election
For recipients of restricted shares in a startup (i.e., private company), equity is often the most valuable part of their compensation packages. However, how and when that equity is taxed will make a significant difference in a founder’s financial outcome from holding and one day selling all or some of this equity. Founders can elect to lock in tax treatment at the time of the grant rather than waiting for their shares to vest. This election is known as an 83(b) election, permitted by section 83(b) of the Internal Revenue Code of 1986, as amended.
What Is an 83(b) election?
When shares vest, it means those shares are no longer subject to a “substantial risk of forfeiture.” Typically, shares vest over some predetermined period of time, such as four years, and/or upon the achievement of certain “milestones,” such as the launch of a new product or achievement of a financial milestone. Shares usually vest only if the recipient continues to provide services to the company during the vesting period or until the specified milestone is reached. If a recipient stops providing services before the vesting period ends or a milestone is achieved, any unvested shares remain subject to a substantial risk of forfeiture and repurchase by the Company, often at cost. In most cases, forfeiture occurs automatically (typically when shares are issued as they vest) or by the company exercising a repurchase right with respect to unvested shares (when shares are issued immediately in escrow and released as they vest).
Shares received by founders and early employees of a startup are usually restricted (as a best practice) because investors and existing stockholders want to motivate founders and founders want to motivate their employees/co-founders to work hard and stick with the company for some period of time to earn the equity or be compensated only for adequate performance in the form of achieving certain milestones. Under U.S. tax law, when you receive restricted stock, the default is that the IRS taxes the recipient when the stock vests. At that time, the holder pays ordinary income tax on the difference between the stock’s fair market value at the time of vesting and what the holder paid for it.
An 83(b) election allows you to elect to be taxed at the time you receive the stock. By doing so, you include the current value (often a nominal amount, especially for early-stage startups where a share in the company is equivalent to the par value of such share being a cent or a fraction of a cent) of the stock in income now (to the extent you didn’t pay for it) and convert future appreciation into capital gain rather than ordinary income. Ordinary income, such as wages or bonuses, is generally taxed at higher rates (up to 37%) than long-term capital gains (up to 20%), which apply to profits from selling stock held for more than a year. (Note, this article does not address or discuss any state and local tax implications or the 3.8% net investment income tax.)
Why Founders Often Benefit from Filing an 83(b) Election
For startups, the company’s common stock typically has very low value at incorporation, and the amount paid for the shares is equal to the value of the stock at that time (i.e., no taxable gain). That means the tax cost of making an 83(b) election is often nominal or zero. Filing an 83(b) election provides several advantages, including:
Reminder: 83(b) elections may only be filed with respect to restricted stock. For example, if a founder purchases 1,000,000 restricted shares of common stock and only 75% of these shares are subject to vesting, you can only file an 83(b) election for 750,000 shares. Some shares not being subject to vesting regularly arises when a founder has been working on the business for some period of time prior to incorporation—like in the above-mentioned exchange scenario—and the business determines they have already earned those shares. Additionally, an 83(b) cannot be filed for the receipt of options subject to vesting as further explained below.
When an 83(b) Election Might Not Make Sense
If there’s meaningful risk that the company will fail or that you’ll forfeit your unvested shares (for example, by ceasing to provide services to the company before all of your shares have vested), the election can backfire. Taxes paid up front are nonrefundable, even if the stock never vests or becomes worthless. If you paid for fair market value for the shares, this risk is not present.
Additionally, if the company’s stock already has measurable value above the price paid for the shares, the upfront tax cost could be significant.
In these cases, consulting a tax professional is essential.
What About Stock Options?
An 83(b) election generally applies to restricted stock, not stock options. However, some option grants can be exercised early, allowing holders to buy the shares (by exercising their option) before they vest (i.e., early). When an option is exercised early, the founder or early employee may file an 83(b) election on those purchased shares. For more information about options generally, please see Equity Compensation Primer: ISOs v. NSOs.
Filing and Deadlines
The IRS requires that an 83(b) election be filed within 30 days of receiving the restricted shares. There are no extensions available. The election must also be shared with the company and attached to the taxpayer’s return for that year. Recently, the IRS announced it would accept electronically filed 83(b) elections. (For more information about the electronic filing process and the traditional by mail filing process, please see our article on Equity Compensation: E-Filing Section 83(b) Elections.)
Additionally, it is sometimes advisable for non-U.S. residents who receive restricted stock in a U.S. company who have never paid U.S. taxes and do not have a social security number or individual tax identification number (for non-U.S. residents), to file an 83(b) election. If you have determined, after consulting your experienced tax and legal counsel that the foregoing applies to you, then you should be aware that obtaining an SSN or ITIN (which is needed to file an 83(b) election) can take more than 30 days. Therefore, it is important to plan ahead and obtain this tax identification number prior to receiving these shares so you can timely file your 83(b) election.
Takeaway for Startups
For startups, encouraging founders and early employees to make 83(b) elections early can help avoid painful tax issues later. Many startups now provide template 83(b) election forms and filing instructions along with the equity paperwork to streamline this process.
Every situation is unique, and founders and early employees should discuss the timing and implications of an 83(b) election with experienced tax and legal counsel.
Note on Tax Advice: This article is provided for informational purposes only and does not constitute legal, tax or accounting advice. Taxpayers should consult their own legal and tax advisors for guidance and assistance in filing their 83(b) elections.
What Is an 83(b) election?
When shares vest, it means those shares are no longer subject to a “substantial risk of forfeiture.” Typically, shares vest over some predetermined period of time, such as four years, and/or upon the achievement of certain “milestones,” such as the launch of a new product or achievement of a financial milestone. Shares usually vest only if the recipient continues to provide services to the company during the vesting period or until the specified milestone is reached. If a recipient stops providing services before the vesting period ends or a milestone is achieved, any unvested shares remain subject to a substantial risk of forfeiture and repurchase by the Company, often at cost. In most cases, forfeiture occurs automatically (typically when shares are issued as they vest) or by the company exercising a repurchase right with respect to unvested shares (when shares are issued immediately in escrow and released as they vest).
Shares received by founders and early employees of a startup are usually restricted (as a best practice) because investors and existing stockholders want to motivate founders and founders want to motivate their employees/co-founders to work hard and stick with the company for some period of time to earn the equity or be compensated only for adequate performance in the form of achieving certain milestones. Under U.S. tax law, when you receive restricted stock, the default is that the IRS taxes the recipient when the stock vests. At that time, the holder pays ordinary income tax on the difference between the stock’s fair market value at the time of vesting and what the holder paid for it.
An 83(b) election allows you to elect to be taxed at the time you receive the stock. By doing so, you include the current value (often a nominal amount, especially for early-stage startups where a share in the company is equivalent to the par value of such share being a cent or a fraction of a cent) of the stock in income now (to the extent you didn’t pay for it) and convert future appreciation into capital gain rather than ordinary income. Ordinary income, such as wages or bonuses, is generally taxed at higher rates (up to 37%) than long-term capital gains (up to 20%), which apply to profits from selling stock held for more than a year. (Note, this article does not address or discuss any state and local tax implications or the 3.8% net investment income tax.)
Why Founders Often Benefit from Filing an 83(b) Election
For startups, the company’s common stock typically has very low value at incorporation, and the amount paid for the shares is equal to the value of the stock at that time (i.e., no taxable gain). That means the tax cost of making an 83(b) election is often nominal or zero. Filing an 83(b) election provides several advantages, including:
- Lock in low value now. At the time of incorporation, the fair market value of common stock might be fractions of a cent per share, making the immediate income (and tax) nominal or zero if the holder pays for the shares.
- Convert future growth into capital gain taxed at the liquidity event. Any later appreciation may qualify for the more favorable long-term capital gains rates, or even Qualified Small Business Stock (QSBS) treatment under Section 1202 of the Code if other requirements are met.
- Start the holding period clock. The one-year period for long-term capital gains and the full five-year QSBS holding period both start when the election is made, not when the stock vests.
- Avoid liquidity crunches later. Without an 83(b) election, you might face a substantial tax bill upon vesting when shares have appreciated, but without available cash to pay those taxes.
- Exchanges for equivalent value. Some startups originally form a limited liability company to run their business. However, because LLC “waterfalls” often complicate how ownership and profit are divided, and startups rarely distribute cash to investors, early-stage investors will typically require an LLC to convert to a corporation prior to investing. In these circumstances, equityholders in the LLC, including founders, will exchange their membership interests or units for shares of stock in the corporation. This exchange is not usually a taxable event. Therefore, there is no tax to pay under an 83(b) election. However, it is still advisable to file an 83(b) election for record-keeping purposes, explicitly stating that no tax is payable in connection with this exchange to avoid any confusion with the IRS (i.e., a protective 83(b) filing).
Reminder: 83(b) elections may only be filed with respect to restricted stock. For example, if a founder purchases 1,000,000 restricted shares of common stock and only 75% of these shares are subject to vesting, you can only file an 83(b) election for 750,000 shares. Some shares not being subject to vesting regularly arises when a founder has been working on the business for some period of time prior to incorporation—like in the above-mentioned exchange scenario—and the business determines they have already earned those shares. Additionally, an 83(b) cannot be filed for the receipt of options subject to vesting as further explained below.
When an 83(b) Election Might Not Make Sense
If there’s meaningful risk that the company will fail or that you’ll forfeit your unvested shares (for example, by ceasing to provide services to the company before all of your shares have vested), the election can backfire. Taxes paid up front are nonrefundable, even if the stock never vests or becomes worthless. If you paid for fair market value for the shares, this risk is not present.
Additionally, if the company’s stock already has measurable value above the price paid for the shares, the upfront tax cost could be significant.
In these cases, consulting a tax professional is essential.
What About Stock Options?
An 83(b) election generally applies to restricted stock, not stock options. However, some option grants can be exercised early, allowing holders to buy the shares (by exercising their option) before they vest (i.e., early). When an option is exercised early, the founder or early employee may file an 83(b) election on those purchased shares. For more information about options generally, please see Equity Compensation Primer: ISOs v. NSOs.
Filing and Deadlines
The IRS requires that an 83(b) election be filed within 30 days of receiving the restricted shares. There are no extensions available. The election must also be shared with the company and attached to the taxpayer’s return for that year. Recently, the IRS announced it would accept electronically filed 83(b) elections. (For more information about the electronic filing process and the traditional by mail filing process, please see our article on Equity Compensation: E-Filing Section 83(b) Elections.)
Additionally, it is sometimes advisable for non-U.S. residents who receive restricted stock in a U.S. company who have never paid U.S. taxes and do not have a social security number or individual tax identification number (for non-U.S. residents), to file an 83(b) election. If you have determined, after consulting your experienced tax and legal counsel that the foregoing applies to you, then you should be aware that obtaining an SSN or ITIN (which is needed to file an 83(b) election) can take more than 30 days. Therefore, it is important to plan ahead and obtain this tax identification number prior to receiving these shares so you can timely file your 83(b) election.
Takeaway for Startups
For startups, encouraging founders and early employees to make 83(b) elections early can help avoid painful tax issues later. Many startups now provide template 83(b) election forms and filing instructions along with the equity paperwork to streamline this process.
Every situation is unique, and founders and early employees should discuss the timing and implications of an 83(b) election with experienced tax and legal counsel.
Note on Tax Advice: This article is provided for informational purposes only and does not constitute legal, tax or accounting advice. Taxpayers should consult their own legal and tax advisors for guidance and assistance in filing their 83(b) elections.