A Founder’s Guide to Making a Section 83(b) Election

Author: Andrew (Drew) Piunti
DPA Law PC
drew@dpalawyers.com

Founders of early stage companies often find the matter of making an 83(b) election filing under the IRS Code perplexing. The question comes into play at the time shares are acquired subject to vesting. Timely filing can protect a founder from significant tax consequences down the line. Below are six questions founders commonly ask:

What is a Section 83(b) election?

It’s a letter one sends to the Internal Revenue Service letting it know you’d like to be taxed on your equity, such as shares of restricted stock, on the date the equity was acquired (or such date the shares first become subject to vesting) rather than on the date the shares vests. Put simply, it accelerates your ordinary income tax. Note that Section 83(b) elections are applicable only to shares subject to vesting. Vesting typically is imposed at the time of purchase under the instrument through which the founder purchases their shares. However, a founder whose shares are not subject to vesting may later agree to vest a portion of previously purchased shares under a lapsing Company repurchase right as a condition to securing a venture capital investment, and, the 83(b) election analysis, which wasn’t at issue before, comes into play.

Founders that decide to make an 83(b) election need to do so promptly to ensure that they do not miss the 83(b) filing deadline. An 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock subject to vesting, or, where vesting is later imposed, within 30 days of such imposition. The last possible day for filing is calculated by counting every day (including weekends and holidays) starting with the day after the grant date (or later imposition of vesting).

What are the benefits of an 83(b) election?

Simply stated, an 83(b) election can result in significant tax savings under the right circumstances. For one, Section 83(b) of the Internal Revenue Code allows founders to accelerate the determination of taxable income on an award or purchase of restricted stock to the date it was granted (or became subject to vesting) rather than on the date(s) the shares vest. If the restricted stock is purchased for an amount equal to its fair market value, an 83(b) election will result in no recognition of income as of the election date. Additionally, an 83(b) election advances the beginning of the one-year long-term capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale (long-term capital gain tax rates are 0, 15 and 20 percent for most taxpayers).

What happens if a founder does not file an 83(b) election?

If a Section 83(b) election is not filed by the deadline, a founder may owe taxes on restricted stock grants at each vesting date. The founder’s tax would be assessed at ordinary income rates on the amount by which the stock’s value on the vesting date exceeds the purchase price, if any. This may result in a significant tax obligation if the value of the shares has increased substantially over time, on “phantom” income: income without receipt of cash.

Can you provide an example of the different outcomes from filing and not filing an 83(b) election?

Assume you receive 1,000,000 shares subject to vesting, worth $.01 per share at the time of grant, $5.00 per share at the time 50% of the shares vest, $10.00 per share when the balance vest, and $15.00 per share when sold more than one year later. Assume you are taxed at the greatest marginal income and capital gains rates.

Example 1 – you file an 83(b) Election

You timely file a Section 83(b) election within 30 days of the restricted stock grant, when your shares are worth $10,000 ($0.01 x 1,000,000). If you pay nothing for your shares, you pay ordinary income tax of $3,700 ($0.01 x 1,000,000 = $10,000 x 37%).  Because you filed a Section 83(b) election, you do not have to pay tax when the stock vests, only on the sale. On the sale (which occurs more than one year after the date of grant) you recognize a taxable gain of $14.99 per share (not $15.00, because you get credit for the $.01 per share you already took into income) and pay capital gains tax of $2,998,000 ($14,990,000 x 20%). Your net economic gain after tax is $11,998,300 ($15,000,000 minus ($3,700 + $2,998,00)).

Example 2 – you do not file an 83(b) Election

Now assume you do not file a Section 83(b) election. You pay no tax at grant (because the shares are unvested), but instead recognize regular taxable income of $2,500,000 when the first half the shares vests ($5.00 x 500,000), and $5,000,000 ($10.00 x 500,000) taxable income when the second half vests, and thus incur ordinary income tax of $2,775,000 (($2,500,000 + $5,000,000) x 37%) at vesting – even though you haven’t sold any shares and haven’t realized any sales proceeds with which to pay that tax. On the sale (which occurs more than one year after the date of vesting) you recognize a taxable gain of $7.50 per share (not $15.00, because you get credit for the $7.50 per share you already took into income) and pay additional tax of $1,500,000 ($7,500,000 x 20%). Your net economic gain after tax is $10,725,000 (15,000,000 – ($2,775,000 + $1,500,000)). This is $1,273,300 less than had you filed an 83(b) election.

What are the risks of an 83(b) election?

Despite its benefits, the 83(b) election is not without risk. Making a Section 83(b) election accelerates the date that taxable income is recognized from the vesting date to the date the restricted stock is granted or purchased. This means that if a founder makes an 83(b) election, pays taxes on income based on the fair market value of the shares on the grant date, and then later forfeits his or her shares, the founder may have paid tax on unrealized income.

What scenarios could make an 83(b) election more or less advantageous?

All things considered, a Section 83(b) election will likely be more (or less) advantageous for a founder in the following scenarios:

What are the steps to filing an 83(b) election?

To make an 83(b) election, the following steps must be completed within 30 days of the grant date:

1. Complete a Section 83(b) election letter.
2. Mail the completed letter to the IRS within 30 days of your grant date:

• Mail the IRS Service Center where you file your tax return.
• If you are signing the election form by hand, be sure to send the original signed form to the IRS.
• Preferably send the letter by certified mail return receipt requested or by Priority Mail with delivery tracking and confirmation capability [Note: cannot send by Fed Ex because the delivery address is an IRS P.O. box. There is, in theory, a fax number to send the election by facsimile. However, in practice, that number seems perpetually busy such that the fax will likely fail.]

3. Retain, and cause, the employing entity to retain, a copy of the election letter to your employer.
4. Retain one copy of the completed and filed letter for your records and retain proof of mailing.

Founders should consult with their tax advisors to determine how a Section 83(b) election applies to their individual circumstances. Note: the 83(b) election (and need to analyze its pros and cons) also comes into play when a stock option recipient receives an option award with a right to early exercise – meaning a right to pay the per share strike price and purchase the options shares before they vest. The application of 83(b) in this context is beyond the scope of this article.

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Disclaimer: This summary is made available by DPA Law PC (the “firm”) for informational purposes only. It is not meant to convey the firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Accordingly, do not act upon this information without seeking counsel from a licensed attorney engaged to provide advice based on your specific circumstances. This article also is not intended to create, and receipt of it does not constitute, an attorney-client relationship. This article is published “as is” and is not guaranteed to be complete, accurate, or up to date.