IRS Section 83(b)

Section 83(b) governs the taxation of property transferred to an employee or other service provider in connection with the performance of services. Thus, it applies to the stock. It does not apply to the options, SARs and RSUs because those are not viewed as grants of the property, but as a promise to do so at some point in the future. Under Section 83(b) a person recognizes an ordinary taxable income when his ownership rights either become transferable or are no longer subject to a substantial risk of forfeiture. Stock in the startup companies is usually subject to vesting. The company has the right to repurchase unvested shares if imposed conditions were not satisfied. Therefore, ownership of such stock is under a substantial risk of forfeiture. If vesting schedule exists, the holder will be taxed on the difference between the fair market value of the vested portion of the stock on each vesting date and the price he initially paid for it. Usually when stock is issued to the employees or founders of a startup company, its fair market value is minimal (can be $0,0001 per share). During the vesting period, however, stock value may increase if business becomes successful. So the difference between purchase price and stock value on each vesting date can be significant. However, stock of the private company is usually completely illiquid. Under such scenario an employee or a founder will have to come up with the out of pocket cash to pay taxes even though he didn’t sell the stock and received sales proceeds, but is holding it. Moreover, the employer will have to pay all employment taxes associated with ordinary compensation of an employee.

 

As an alternative to recognizing taxable income upon each vesting date, the recipients of the restricted stock should always consider filing an election under Section 83(b) of the Internal Revenue Code. By filing a timely Section 83(b) election, the holder elects to pay tax at the time the stock is granted. If the holder pays full market value at the time of the grant, no tax will be due because the value of the stock on that date will not exceed the purchase price. Once this election is made, subsequent vesting of the stock will not be taxable. The founder will be required to pay tax only when the stock is ultimately sold. Any gain recognized on the sale will be taxed as a capital gain and if the stock was held for more than a year it will be taxed as a long-term capital gain at a much lower rate than ordinary income. Making 38(b) election not only allows to deferred taxation until the final sale of the stock, but also starts the counting period to qualify for a long-term capital gains tax treatment.

 

An 83(b) election must be filed with the Internal Revenue Service within 30 days of the initial grant of the shares. 30 days are counted included weekends and holidays. No exception to this filing requirement exists. If filing was not timely made, the right to do so is lost irreversibly.

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