What is an 83(b) election?

Failing to make a timely 83(b) election with the IRS could have serious tax ramifications for a startup founder or employee who owns shares in a company that are subject to vesting. The general rule is that taxes are due when a person receives income. The value of the shares is certainly considered income, regardless whether it’s realized or unrealized. A person does not receive a profit if the ownership of the shares is conditional, subject to forfeiture (if vesting is imposed, it is, because company has the right to forfeit unvested shares if certain conditions are not met). Taxes are due only if and when the ownership becomes unconditional. What it means in terms of tax schedule? If stock were subject to a four-year vesting and a certain % of shares vests on monthly bases, a holder would recognize income equal to the difference between the fair market value at the time of vesting and the value at the time he/she received the shares. This income is taxable. Even if the holder does not sell shares, he/she has to come up with money to pay taxes. What makes it worse, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.

 

Not everything is so gloomy if an 83(b) election is timely made. If a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock. For example, a founder purchases stock for $0.01 per share and the stock is subject to four year vesting with a one-year cliff. The founder makes an 83(b) election and pays all taxes due at the time of purchase (based on a fair market value of $0,01 per share). At the end of the one-year cliff, if the stock is worth $1.00/share when it vests, the founder recognizes $0.99/share of income. Without 83(b) election, the founder would have to pay tax on the profits, which are equal to $0.99 per share. Then as the remainder vests each month, the founder would receive income equal to the difference between the fair market value and $0.01/share (the amount he bought it at). By making an 83 (b) election the founder pays takes on unvested shares at the time of purchase when the value is usually minimal. Then no tax is due at the time of vesting, when market value can grow significantly. The holder will not have to pay taxes until he/she sells the share at a profit.

 

Another benefit is that recognizing the purchase of all shares, including unvested ones, starts the count towards the asset-holding period. When a person sells assets, which he held for longer than one year, the income received from such sale is taxable at the rate of long-term capital gains, which is much lower than ordinary income rate.

 

Thus, a founder/employee of a startup should almost always make an 83(b) election.

 

It is important to notice, that an 83(b) election will be effective only if timely made. It should be filed with IRS prior to the date of the stock is received or within 30 days after the stock is received. There are no exceptions to this rule. 30 days are calculated by counting every day (including Saturdays, Sundays and holidays) starting with the next day after the date on which the stock is purchased. If purchased on November 15, an 83(b) election should be filed before December 14. Accordingly, it is vitally important that all transactions involving shares/equity interest in the company are supervised by an experienced business lawyer. The consequences of small mistakes or overlooks can be irreversible.

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