What is an 83(b) Election and How Does It Function in Practice? is Part of our Startup Law 101 Series.
This essay aims to provide startup founders with the information they need to understand the 83(b) election.
This is a nuanced area of taxation, and the information provided here is meant only as a primer on 83(b). Consult with seasoned tax experts to help you navigate this minefield.
The general rule for founders is as follows: Section 83(b) applies only if the founder holds stock and can lose economic value if the stock is sold. If any of these conditions apply to the founder’s situation, the 83(b) election must be filed no later than 30 days after the founder receives the stock grant, or the founder may suffer adverse tax consequences.
The big image looks like that. Here we get into the tax theory and a fuller breakdown.
Services rendered in exchange for the property are subject to the provisions of Internal Revenue Code Section 83.
Internal Revenue Code section 83(b) details the taxation of tangible personal property a service provider receives in return for those services.
The primary purpose of subsection (b) of section 83, which is linked to subsection (a) by several citations, is to alter the tax repercussions that would otherwise apply to service providers under subsection (a). (a).
Consequently, 83(b) requires familiarity with 83 to be comprehended. (a).
The timing and method of taxation of such service-related income are laid out in Section 83(a).
If I receive property in return for my services, the difference between the fair market value and the amount I paid is subject to taxation under section 83(a).
Therefore, service suppliers who accept the property as payment fall under the purview of Section 83(a). Who is the startup’s primary source of service provision? The outside expert is not the problem. The founder puts in their own time in exchange for stock.
But let’s tackle things one at a time.
If I am an expert and receive $5,000 worth of stock in exchange for my services rendered to a startup, I will be required to pay taxes on $5,000 of service income, or the $5,000 value of the stock minus the $0 cost to acquire it. I have to pay taxes on the differential.
In other words, everything looks fine so far. Much is true.
However, there is more nuance to Section 83(a).
The founder, who must work for his equity over time, is considered a service supplier for tax purposes under Internal Revenue Code section 83. (a). The IRS views the stock as being given in exchange for services, even if the founder paid petty cash for and owns the shares. This is because the founder’s ownership can be forfeited when the founder’s service relationship with the company is ended.
Therefore, founder grants that carry a risk of forfeiture come within and are taxable under 83. (a).
However, such grants are not subject to taxation when they are made under Section 83(a). Such awards are liable to tax under a special rule only once there is no longer a “substantial risk of forfeiture.”
This unique law makes startup situations hazardous for the unwary.
Founders’ Worst Tax Fears Realized
To illustrate, suppose a founder receives 2,000,000 shares at $.001 per share and spends $2,000 total. The shares vest monthly at a rate of 1/48th over four years. Can you explain how section 83(a) applies here? According to Section 83(a), no tax is due at the start of the grant and is considered 100 percent “subject to a substantial risk of forfeiture.” How does the monthly vesting of 1/48th of the shares work, though? Once claims have vested, they are no longer in danger of being taken away. Therefore, for a founder who holds shares subject to Section 83(a), each vesting event constitutes a possibly taxable event.
The founder may initially face minimal risk if the business maintains its current stock price of $.001 per share. However, what occurs during initial funding? The stock price rises, obviously, usually quite a bit. Let’s pretend the business decides to set the price of its common stock at $.20 per share following a Series A round. After that occurs, Section 83(a) requires the original grantee to pay tax at each vesting point under the terms of his grant.
How does he get taxed? Based on the difference between the purchase price and the fair market value of the shares that have just vested (because the forfeiture limitations have expired as to those shares). In our case, this would result in monthly taxable income for the founder of $.001 per share, or $.20 total, for all claims that vest during that month. All of the founder’s insistence that vest after the re-pricing event would be subject to a tax on the difference between $1.00 per share and $.001 per share if another financing were to occur and the common stock was re-priced to $1.00 per share. To put it another way, the founder may soon be facing a financial nightmare. A new and possibly enormous tax hit awaits him with each of his many remaining vesting points. For the privilege of holding paper he could not liquidate even if he tried, he would incur taxable income of just under $500,000 in the final year of his vesting cycle alone (12 taxable events, assuming the common stock were valued at $1.00 per share during that period).
With this information, we can grasp an 83(b) election and why it is so crucial.
To Save the Day, There’s Section 83(b)
While Section 83(a) outlines the broad principles that govern the taxation of service providers who receive stock in return for their labor, Section 83(b) provides a way out of the nightmare tax scenario mentioned above.
By making a one-time election under 83(b), a recipient of stock exposed to a substantial risk of forfeiture can avoid paying tax on his interest in the store on a prorated basis as the restrictions on penalty expire.
If the founder above makes a timely 83(b) election on his 2,000,000 share grant, he will be required to pay tax on the difference between the $.001 per share purchase price and the fair market value of the stock received as of the date of grant. That is to say, if the stock is now worth $2,000 and the founder spent $2,000 for it, he will owe tax on the difference of $400. The tax is $0.00 because there is no distinction between the two. This 83(b) procedure replaces the 83(a) treatment that would typically apply, avoiding the nightmare above tax situation.
Once the 83(b) decision has been made, neither the initial grant nor the founder’s future taxable income from the vesting of the shares is subject to taxation. For calculating capital gains, his holding period will begin at the moment of issue, and he will only be subject to a capital gains tax when he sells these shares.
This much for speculation.
Advice on Putting Section 83(b) Into Practice
So, what does this imply for startups?
1. It is a common misconception among founders that they must file Form 83(b) concerning stock grants because “that is how startups work.” Form 83(b) filings are required only when a founder is awarded “restricted stock,” a type of stock subject to forfeiture upon the founder’s separation from service to the company.
2. Grants of free stock to founders or anyone else do not trigger 83(b) votes because there is no significant risk of forfeiture.
3. In traditional buy-sell agreements, which are rarely used in startups, 83(b) does not apply if the business can repurchase even the vested stock of a departing founder at its fair market value upon termination of a service relationship. If the reserve is repurchased at a price close to its current market worth, there is little to no chance of losing money. Therefore, there is no need to file an 83(b).
4. Vesting is almost always used when a startup gives stock options to its essential employees. In general, chances are governed by a complex set of tax regulations, but Section 83(b) has no impact on any of them, with one exception. If key employees are offered the option to exercise their options early, and they do so, the employees will receive stock that is subject to forfeiture if the employees do not meet the required period of service. An 83(b) election must be submitted when such options are exercised to avoid having the recipient pay tax at each vesting milestone, just as the founder did in the preceding example. Stock options are not subject to Section 83(b) except in the event of early exercise.
5. The service supplier might not always appear ahead after making an 83(b) election. Employees of established businesses may be offered restricted stock at a significant reduction, prompting them to file an 83(b) election and pay tax immediately on the difference between the stock’s fair market value and the amount paid for it. Such grants were common during the bubble period because they were given with the expectation that the recipient would benefit from the company’s eventual IPO. The recipient may end up spending a hefty tax due to making the 83(b) election, which is essentially a tax for the right to possess the paper. In the event of the company’s failure, the 83(b) decision could result in the payment of an unnecessary and potentially crippling tax bill. (a tax payment that is not deductible either). Extreme caution must be exercised when a sizable tax obligation arises due to making an 83(b) decision.
6. The deadline for filing an 83(b) election is 30 days after the date of issuance. Doing so involves submitting paperwork to the IRS. The recipient and their spouse (if applicable) must sign the choice. In addition to submitting his annual tax return, the taxpayer must also submit a duplicate of his 83(b) election for that year. These regulations are particular and must be followed precisely.
In sum, enlist expert assistance to get the job done right.
So concludes our sightseeing trip designed to enlighten the founder about the 83(b) ballot. This is not exhaustive, and no action should be taken in this field without consulting with an experienced business lawyer. Use this as a foundation for further study, and then hire qualified experts to assist you in putting the necessary pieces into place.
George Grellas, 2009, all rights reserved.
George Grellas is a business and company lawyer in Silicon Valley who focuses on helping startups. Since 1984, his firm of startup business lawyers has assisted several thousand entrepreneurs and their companies in Silicon Valley and around the globe. The firm handles corporate work, employment work, contracts, leases, standard terms, licensing, trademarks, IP work, founder and equity incentive structures, and commercial transactions. The company, corporate, contract, fraud, trade secret, unfair competition, employment, company break-ups, and commercial litigation, in general, are all areas in which the firm has experience.
The essay was initially published in the firm’s startup business attorney advice section of their website, where you can also find similar pieces in the Startup Law 101 Series.
This document is not intended to, and should not be used as, legal counsel. The text only provides broad educational guidelines. Talk to a counselor near you about your specific situation.