Startup founders are often ill-informed about what an 83(b) election is. This article is aimed at giving a simplified tour through the realm of 83(b) so that founders can have a clear (if general) sense of what the 83(b) election really means.
This is a complex tax area and what is presented here is not intended to cover all aspects of the tax rules. It is intended only to clarify misconceptions often held by founders and to give a general picture of how 83(b) works. It is critical that founders in real-world companies work with skilled tax professionals on these issues. The area is full of landmines.
Here, though, is a simple tour through the landscape.
Section 83(b) is part of Internal Revenue Code section 83, which specifies how service providers who received property in exchange for their services are to be taxed on that property.
Section 83(b) is intimately connected with section 83(a) and works really only to modify certain tax consequences that would otherwise apply to service providers under 83(a).
Therefore, 83(b) cannot really be understand without a basic understanding of 83(a).
So, here it is — a much simplified explanation of 83(a) that is not intended to cover all its dimensions but instead to give only a basic working knowledge to founders of some of its important principles.
Under 83(a), if I get property in exchange for my services, I pay tax on the excess of the fair market value of that property over what I paid for it.
Section 83(a) applies, then, to service providers who take property as payment for services. Who is the major service provider in a startup? No, it is not the outside consultant. It is the founder who works for sweat equity.
But let us take the cases in sequence.
If I am a consultant, and I get $5,000 worth of stock for my work done for a startup, I pay tax on $5,000 worth of service income — that is, on the difference between the worth of the stock ($5,000) and what I paid for it ($-0-). That difference is taxable to me.
So far so good. That much is intuitive.
But 83(a) is more complex than that.
The founder who has to earn his shares over time is also treated by the IRS as a service provider under 83(a). The founder may pay nominal cash for the shares and may own them, but as long as that ownership can be forfeited when the founder’s service relationship to the startup is terminated, the IRS sees the stock as having been granted in exchanges for services.
This brings all such founder grants — that is, grants that must be earned out or, in other words, are subject to a risk of forfeiture — under 83(a).
But 83(a) does not impose an immediate tax on such grants at the time they are made. It has a special rule that taxes such grants only when they are no longer subject to a “substantial risk of forfeiture.”
It is this special rule that creates traps for the unwary in the startup context.
Let’s assume that a founder is granted 2 million shares at $.001 per share and pays $2,000 for them. The shares vest ratably over 4 years at the rate of 1/48th per month. How does 83(a) apply to this scenario? Under 83(a), the tax authorities see the grant initially as being 100% “subject to a substantial risk of forfeiture.” Thus, no tax arises at the outset. But what then happens each month as 1/48th of the shares vest? Well, those shares are no longer subject to any risk of forfeiture. Under 83(a), then, each incremental vesting event creates a potentially taxable transaction.
The risks to the founder may be slight at first when the stock remains priced by the company at the $.001 per share level. But what happens on first funding? Of course, the price of the stock goes up, often dramatically. Let’s say, after a Series A round, the company prices its common stock at $.20 per share. Once that happens, under 83(a) the founder holding the original grant is required at each of his vesting points to pay tax on the difference between the fair market value of the stock received as to which forfeiture restrictions have been lifted, on the one hand, and the price he paid for that stock on the other. In our example, this would mean the founder realizes taxable income on the difference between $.20 per share and $.001 per share for each of the shares that vest each month. If another funding occurs, and the common stock is re-priced to $1.00 per share, then all of the founder’s shares that vest after that re-pricing event trigger a tax on the difference between $1.00 per share and $.001 per share. In other words, the founder finds himself in the middle of a potential tax nightmare.
With this background, we can understand the essence of an 83(b) election.
While 83(a) sets out the general rules for how service providers are taxed when they exchange services for stock, 83(b) gives them an out from the nightmare tax scenario noted above.
Under 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can make a one-time election to have his entire interest taxed once-and-for-all at inception instead of having it taxed incrementally over time as the restrictions on forfeiture lapse.
This means that, if the founder mentioned above, makes a timely 83(b) election on his 2 million share grant, he elects to pay tax on the difference between the fair market value of the property received as of the date of grant (here, the stock, which has a fair market value of $.001 per share), on the one hand, and the amount he paid for it, on the other. In other words, the founder will pay tax on the difference between the $2,000 that the stock is worth and the $2,000 he paid for it. Since there is no difference between the two, the tax is $-0-. This 83(b) process is in lieu of the 83(a) treatment that would otherwise apply and eliminates the nightmare tax scenario discussed above.
With the 83(b) election once made, the founder pays no tax on the grant at inception and incurs no taxable income as the shares vest over time. His holding period commences at inception for capital gains purposes and the only tax that would apply to such shares would be a capital gains tax at the time of sale.
So much for theory.
What does this mean in practice for founders?
- Many founders routinely assume they need to do 83(b) filings in connection with their stock grants because “that is how startups work.” In fact, 83(b) filings are only required in cases where the founder grants consist of so-called “restricted stock,” which is a form of stock where the founder’s stock is subject to forfeiture on termination of his service relationship with the company.
- If unrestricted stock grants are made to founders or others, 83(b) elections do not apply because the stock is not subject to a substantial risk of forfeiture.
- While not often used in startups, in conventional buy-sell agreements, if a company can buy back the stock of a departing founder at its fair market value on termination of a service relationship, 83(b) doesn’t apply. If the buy-back is at fair market value, there is no “substantial risk of forfeiture” of the economic value of the stock. Thus, no 83(b) filing is necessary.
- When a startup grants options to its key people, vesting is almost invariably used. Options in themselves are subject to a complex set of tax rules but 83(b) has no bearing on any of them except for one special case. If options are granted to key people and they are given the right to exercise them early, such recipients will get stock that is subject to forfeiture in the event they do not earn it out through a prescribed period of service. Because of the risk of forfeiture, an 83(b) election needs to be filed or these recipients may wind up being taxed incrementally at every vesting point, just as described in the example above with the founder.
- Sometimes it is unwise to file an 83(b) election. Not every stock grant that is subject to a forfeiture risk is granted at a cheap price. Sometimes a CEO, for example, is brought into a late-stage startup and given a large grant of restricted stock at a comparatively high price. During the bubble era, this was often done in anticipation that the CEO would profit after the company went public, notwithstanding the high price paid for the shares at the time of the grant. In such a case, the recipient may wind up paying a substantial tax in connection with making the 83(b) election. In this case, the 83(b) election leads to payment of a much higher tax than otherwise would have been paid.
- Procedurally, an 83(b) election must be made within 30 days of the date of the original grant. This is done by a filing with the IRS. The election must be signed by the recipient and any spouse. The taxpayer must also file a copy of the 83(b) election with his tax return for that year. These rules are strict and must be complied with to the letter.
That ends our tour for the benefit of giving the founder a bird’s-eye view of the 83(b) election. Again, this is by no means complete and nothing is safe in this area unless done under the supervision of a good business attorney. Use this for your working knowledge and then make sure to do it right.