“By failing to prepare, you are preparing to fail”
Every startup founder that uses vesting schedule should know about the 83(b) election. Those first-time entrepreneurs who simply do not know about 83(b) often live to regret it. With no 83(b) election, a startup founder or employee may end up with a large tax bill at a time when their stock is still illiquid. The 83(b) election is extremely useful and can result in staggering tax savings.
83(b) Election 101: When is it Needed?
You do not need to make the 83(b) election if:
- You have stock options and you will not exercise the option early.
- You purchased stock that you received right away – that is, there’s no milestone or time-based vesting schedule.
You almost always need to file an 83(b) election when: you purchased or received stock as a founder, employee or service-provider and the stock are subject to a vesting schedule.
Stock as “Sweat Equity” is Income
When you received stock subject to vesting, the stock is considered payment for the future services you will be performing for your startup. In the eyes of the IRS it is considered compensation, just like a paycheck. How much taxes you will pay on sweat equity depends on whether the 83(b) election was properly and timely made.
The Advantages of the 83(b) Election
By making the election, you commit to paying taxes now (next April really) on the difference between what you paid for the stock and the fair market value of the stock. The advantages of the 83(b) election is that you often pay little to no taxes now, at a time when the fair market value of the stock is often minimal and get to pay no taxes later either, as the stock increases in value.
Without the 83(b) election, no taxes are due upfront. Instead, you will incur tax liability for the difference between the purchase price (the price you paid for the equity) and the fair market value of the stock every time some stock vest. Accordingly, if the startup becomes more valuable, you incur an increasing tax liability as its value grow while at the same time receiving no income from that stock – remember that the stock is highly illiquid. So you may be in the awkward position of incurring a high tax bill every year without receiving any money to pay for it.
Because the value of the stock might increase substantially by the time it vests, the 83(b) election is a great way to minimize your tax liability. Additionally, if you choose to acquire your stock at fair market value, no tax is owed at all. This is particularly useful for startup founders who can pay a nominal price for the stock as long as they sign their restricted stock purchase agreement in the early days – usually right after incorporation.
Time is of the Essence: Within 30 days
An 83(b) election has to be filed with the IRS within 30 days of the purchase of the stock. These 30 days usually go by very quickly so it’s a good practice to file the 83(b) election right after signing the restricted stock purchase agreement.
83(b) Election Steps-by-Steps
For the 83(b) election to be effective, certain formalities must be strictly followed:
Step 1. Complete and File the 83(b) Election
Ask the company attorney to provide a sample 83(b) election form and associated cover letter. If the company does not provide it, have your attorney prepare one for you.
Step 2. Within 30 days, Send 2 Copies to the IRS and 1 to the Company
Make sure to send two copies to the IRS, one of which via certified mail return receipt requested, within 30 days. The other, with a self-addressed postage-paid enveloped. A third copy is sent to your company and you should keep a fourth one, for safekeeping.
Step 3. Attach a Copy of the 83(b) Election with your Personal Tax Return
Next April, a copy should be filed with your tax return.
Setting a vesting schedule is a complex legal topic on its own, which is compounded by the tax implication and related 83(b) election issues. Feel free to contact Buchwald & Associates directly if you’d like to discuss any point in greater details.