To 83(b) or Not to 83(b) (Part 1 of 2)
Founders and early employees of a company often receive equity as compensation. Like any other kind of compensation, these grants of equity are subject to taxes as ordinary income. The tax liability for the founder or employee will be based on the fair market value of the equity received less any capital paid for that equity. This is all straightforward when the equity is not subject to any restrictions. The individual that receives the equity will recognize ordinary income in the year the equity was received.
What happens when the equity is subject to restrictions? A common arrangement in startups is to have these initial grants of equity subject to time-based vesting restrictions. This means that while the recipient owns the equity, the company can repurchase the equity if the recipient’s service to the company terminates. As the recipient reaches certain time-based milestones, the company’s repurchase option will begin to lapse. Under these circumstances, the IRS does not recognize this equity as ordinary income until it actually vests. This may seem advantageous—why pay taxes now when the IRS will let you pay them later? However, this is not the case for the vast majority of entrepreneurs.
When to be Taxed
The problem with paying taxes on equity as it vests is that the tax liability will be based on the value of the equity at the time of vesting. This means that if a startup is successful and grows in value, the amount owed in taxes will continue to grow over the lifetime of the vesting schedule. Compounding the problem is that the holder of the equity typically cannot sell it (due to the lack of a market and other restrictions placed on the equity). Therefore, the holder is recognizing taxable income even though it is not actually receiving any monetary income from which it can actually pay the income taxes owed. If only there was a way to pay taxes on all of the equity at the point it was initially granted and worth only pennies. Fortunately, the IRS has provided such an option for startups.
Under 26 U.S.C. §83(b), a founder may elect to recognize equity as taxable ordinary income at the time of grant. This “83(b) election” allows you to pay all taxes up front when the equity is worth very little as opposed to paying taxes over time when the equity vests and is growing in value. Moreover, because most founders will pay for their founder’s equity in the form of a nominal capital contribution, there is actually no ordinary income recognized. If you receive restricted equity in a growing startup, you should almost always make this 83(b) election.
The most important thing to know about filing an 83(b) election is that it must be done within 30 days of the date that you receive the restricted equity. This is a firm deadline and the opportunity to make an 83(b) election will be lost after the 30 days expire. The election should be mailed to the IRS Service Center where you would normally file your personal tax return. You should then retain a copy of the election and make sure to include the election when you file your annual tax return. While the IRS does not provide an official form for 83(b) elections, the text of a sample 83(b) election follows:
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 NAME: _____________________________________________
TAXPAYER’S SOCIAL SECURITY NUMBER: __________________________
TAXABLE YEAR: Calendar Year 20__
2. The property which is the subject of this election is __________ shares 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 × ________ shares = $___________.
6. For the property transferred, the undersigned paid $______ per share x _________ shares = $______________.
7. The amount to include in gross income is $______________. [The result of the amount reported in Item 5 minus theamount 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.
Also see Part 2 of 2 on 83(b) elections.