What is an 83(b) election and why is it important?

Takeaway: FILE YOUR 83(B) ELECTIONS ON TIME! Set a calendar reminder, write a note, do whatever you have to so you don’t forget. There are usually ways to fix most of the legal problems startups run into but there is no perfect fix for a missed 83(b) election and the tax issues it brings up are a pain.

An 83(b) election is a provision under the US tax code that allows an individual to elect to pay taxes on the fair market value of unvested property received, such as restricted stock, at the time of grant rather than at the time of vesting. This election is particularly important for early-stage startups because it can provide significant tax benefits to employees and founders.

What is an 83(b) Election?

83(b) elections only apply to shares that are subject to vesting. An 83(b) election allows an individual who receives unvested property, such as restricted stock, to elect to pay taxes on the fair market value of the property at the time of grant rather than at the time of vesting. This can provide significant tax benefits to the individual, particularly if the value of the property increases over time.

How Does an 83(b) Election Work?

To make an 83(b) election, the individual must file a written statement with the IRS within 30 days of the grant of the property (i.e., the shares). The statement must include the fair market value of the property at the time of grant, the amount paid for the property (if any), and other relevant details. The individual must also provide a copy of the statement to the company.

Once the 83(b) election is made, the individual will pay taxes on the spread between the fair market value of the property at the time of grant and the amount paid for the property, even if the shares have not yet vested. The reason we do this immediately when shares are purchased is that the spread between the value and what you paid is typically $0 so your tax is… $0. This can result in significant tax savings if the value of the property increases over time as is the intention with shares in a startup.

Why is an 83(b) Election Important for Early-Stage Startups?

Early-stage startups often offer equity compensation, such as restricted stock, to employees and founders as a way to attract and retain talent and such equity compensation is often subject to vesting. By making an 83(b) election, employees and founders can pay taxes on the fair market value of the equity at the time of grant, which is often significantly lower than the value at the time of vesting. This can provide significant tax savings and reduce the overall tax burden on the individual.

Additionally, early-stage startups often experience significant growth and may have a higher likelihood of the value of the equity increasing over time. By making an 83(b) election, the individual can lock in the lower tax rate at the time of grant and potentially save a significant amount of money in taxes if the value of the equity increases.

What happens if I fail to file an 83(b) election within the 30 day window?

The most immediate consequence is that the founder or employee will be subject to taxes at the time of vesting, rather than at the time of grant. This means that the founder or employee will have to pay taxes on the difference between the fair market value of the stock at the time of vesting and the price paid for the stock (if any). The company will also be required to withhold taxes, which poses a problem when there is no cash paid out to the employee as is the case with illiquid shares of a startup. The kicker is that typical vesting terms are 4 years with a 1 year cliff, which means that on the one-year anniversary, there will be a big tax bill and each month after that for the next 3 years there will be smaller tax bills.

Failing to file an 83(b) election can also create potential legal and regulatory risks for the company. In some cases, the failure to file an 83(b) election can be viewed as a violation of securities laws, which can lead to fines and other penalties. Additionally, if the value of the stock increases significantly over time, the founder or employee may be more likely to challenge the company's handling of their equity compensation, which can result in legal disputes and reputational damage.

Is there any way to fix a missed 83(b) election filing?

There are very limited ways to mitigate the tax liability from a missed 83(b) filing. The most common way is to make the stock transferable to other stockholders of the company though this carries some risk that the IRS will still attempt to impose taxes for failing to file an 83(b) election.

Conclusion

File your 83(b) elections on time for stock subject to vesting!

An 83(b) election is an important provision under the US tax code that allows individuals who receive property subject to vesting to pay taxes on the fair market value of the property at the time of grant rather than at the time of vesting. This can provide significant tax benefits to employees and founders of early-stage startups, who often receive equity compensation as a way to attract and retain talent. By making an 83(b) election, individuals can lock in a lower tax rate and potentially save a significant amount of money in taxes if the value of the equity increases over time. It is very important to timely file an 83(b) election to avoid substantial tax liability for both the stockholder and the company.