Entrepreneurs need to be aware of the 83(b) election. In simple terms, you are taxed on any equity compensation that you receive in the same way that you are taxed on your other income. The IRS requires you to pay taxes on that equity compensation in the year that it is actually transferred to you.
Founders’ stock is often subject to incremental vesting over a number of years. If the founder does nothing, she would incur tax liability for the value of the stock at the time it vests. Assuming that the value of the stock price is rising over the course of the vesting schedule, the value of the stock at the time of vesting could continue to increase (or fluctuate) so that the founder pays more taxes over time.
Rule for Unvested or Restricted Property
Subject to a “Substantial Risk of Forfeiture”
The fair market value of the property is NOT included in the income of the service provider at the time of grant. Instead, the taxpayer includes the fair market value of the property at the time of vesting . The taxpayer’s holding period for long-term capital gains begins on each separate block of property as it vests.
Fortunately, the Internal Revenue Code created an attractive option for startup founders with Section 83(b) of the Internal Revenue Code. The 83(b) election provides founders with the option to be taxed for the entire amount of stock that is subject to vesting at the present value. By making an 83(b) election, you pay tax when you receive the stock, but not when it vests. Regardless of whether the election is made, you will also report capital gain or loss when you sell the stock.
Section 83(b) is an election that allows a taxpayer to “elect” to treat unvested or restricted property as fully vested for tax purposes and pay the tax at grant rather than at time of vesting – and starts the holding period for long-term capital gains. By accelerating the timing of the taxation, the taxpayer is “betting” that they will (a) meet the conditions of vesting and (b) the property will increase significantly in value. If these two events happen, the taxpayer will be able to capture tax significant tax savings because of the lower tax rates on long-term capital gains.
Vested or Unrestricted Property
The fair market value of the property is included in the income of the service provider (as ordinary income) at the time of grant. The taxpayer’s holding period for long-term capital gains begins immediately.
Section 83(b) Election
Within 30 days of grant (the election MUST be made within 30 days of grant), the taxpayer can file an election with the Internal Revenue Service to treat the unvested/restricted property as vested immediately at the time of grant. The taxpayer must include the fair market value of the property in income and pay the corresponding tax.
Do note –
- If you have stock options, you do not need to file an 83(b) Election Form.
- If you purchased/received founder’s stock and there are no restrictions, such as vesting, you do not need to file an 83(b) Election Form.
- If you purchased/received restricted stock in a growing startup, you should consider filing an 83(b) Election Form.
- The election makes sense if the price rises. Remember that most start ups fail so you could end up overpaying tax. Check out this Wall Street Journal article
There is a sample election on the IRS site – http://www.irs.gov/irb/2012-28_IRB/ar12.html#d0e3012
Section 83(b) Election
|The undersigned taxpayer hereby elects, pursuant to § 83(b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess (if any) of the fair market value of the shares described below over the amount paid for those shares.|
|1.||The name, taxpayer identification number, address of the undersigned, and the taxable year for which this election is being made are:|
|TAXPAYER’S SOCIAL SECURITY NUMBER:|
|TAXABLE YEAR: Calendar Year 20|
|2.||The property which is the subject of this election isshares of common stock of .|
|3.||The property was transferred to the undersigned on [DATE].|
|4.||The property is subject to the following restrictions: [Describe applicable restrictions here.]|
|5.||The fair market value of the property at the time of transfer (determined without regard to any restriction other than a nonlapse restriction as defined in § 1.83-3(h) of the Income Tax Regulations) is: $per share xshares = $.|
|6.||For the property transferred, the undersigned paid $per share xshares = $.|
|7.||The amount to include in gross income is $. [The result of the amount reported in Item 5 minus the amount reported in Item 6.]|
|The undersigned taxpayer will file this election with the Internal Revenue Service office with which taxpayer files his or her annual income tax return not later than 30 days after the date of transfer of the property. A copy of the election also will be furnished to the person for whom the services were performed. Additionally, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which the property is transferred. The undersigned is the person performing the services in connection with which the property was transferred.|
Section 83(b) allows Executive B to “elect” (MUST be within 30 days of grant) to treat the shares as vested/ unrestricted at the time of grant for tax purposes.
In addition to paying the tax immediately, there is no ability to claim a loss if she does not meet the vesting requirements and has to forfeit any portion of the stock. Also, the “tax benefit” demonstrated above ONLY applies if the stock is appreciating in value. If the stock stays flat or depreciates in value, then there is no benefit and the taxpayer has only accelerated the timing of her income inclusion. Thus, a taxpayer should consider avoiding Section 83(b) inclusion when they believe they may not meet the vesting requirements and/or the property may not appreciate in value – especially if the current inclusion of income is significant. However, if the current inclusion is minimal (because the property has little or no value at the time of grant), then a Section 83(b) election may be a very good bet, regardless.
We have done 83b elections for non-US Persons in the past, in the context of pre-immigration planning. How? We marked “applied for” and did not experience any pushback in regard to the future vesting schedule and subsequent disposition