Making an IRS Section 83B election
While speaking to a friend that is starting a company I realized that I haven’t written about filing an 83b Election. The election is a very important step in new company formation and if forgotten can have painful tax consequences.
I use stock vesting to refer to both traditional options vesting agreements and the buy-back restrictions on granted stock. In practice the two approaches generally serve the same purpose: to grant stock rights to an employee over time.
What is an IRS Section 83B Election?
The Section 83B election allows employees to change the tax treatment of a restricted stock grant. Normally, employees pay regular income tax when the stock vests (the restrictions lapse) and no tax when the restricted stock is granted.
The 83B election allows employees to pay income tax on the initial grant instead of paying tax when the stock vests. More specifically, they pay tax on the difference between the amount they paid and the Fair Market Value (FMV) of the stock.
Since the FMV of a brand new enterprise is generally close to zero, most founders purchase their stock at FMV. If the founders file an 83B, they end up paying no tax at purchase and no tax when the stock vests. They will only need to pay capital gains tax when the stock is sold.
The 83B election only applies to restricted stock – it only deals with the recognition of income on stock that has restrictions that lapse.
Let’s use an example to illustrate the effect of making (or not making) the election. We’ll consider a founder that is subject to a 4 year annual vesting schedule:
At formation, the company stock is determined to have a FMV of $0.001 per share and he is granted 100,000 shares. The firm grows and the FMV increases to $.10 in Y1, $1.00 in Y2, $10 in Y3, $100 in Y4 (nice growth curve). Assume a 40% regular income tax.Initial Stock Purchase: $100
Value of stock that vests in Y1: $2,500
Value of stock that vests in Y2: $25,000
Value of stock that vests in Y3: $250,000
Value of stock that vests in Y4: $2,500,00083b election filed
Taxes Due at Purchase: $0
Taxes Due at Vesting Intervals: $0
At the end of the 4 years, the founder owns all of his stock outright and has paid no taxes on it. Should he sell the stock, he would be subject to long-term capital gains taxes.No election made
Taxes Due at Purchase: $0
Taxes Due at Vesting Intervals: Y1: $1000, Y2: $10,000, Y3: $100,000, Y4: $1,000,000
Total taxes paid: $1,111,000
And these taxes had to be paid before the company ever had a liquidating event (the founder never received cash for his stock).
Even worse, if the company collapses in Y5 the founder will have paid over $1M in taxes and never received any cash for his stock.
When do you need to make an 83B Election?
Within 30 days of assuming stock ownership. This rule is notoriously inflexible. The election form must be sent to the IRS within 30 days of the grant.
83B applied to startups
The 83B is typically relevant in two scenarios:
- Restricted stock agreements for founders. The most common scenario is the restricted stock agreements of founders. Founders should usually draft and sign restricted stock agreements at the same time that they purchase their initial shares.
A common scenario is one where founders don’t draft vesting agreements when they form the company. Some time later, the company takes investment and the investors require that the founders accept restrictions on their existing stock.
Since the stock in question was granted more than 30-days ago, filing an 83b might not be an option.I’ve received distinctly opposing views from lawyers on this scenario, and a recent ruling (Revenue Ruling 2007-49) by the IRS provides some, but not necessarily full guidance.
Creating stock vesting agreements after the 30-day 83B window is tricky and can require new stock grants that dilute the initial holdings. Altering existing vesting agreements is much more straightforward and is directly addressed by the IRS ruling mentioned above (and typically allows the original 83b filing to remain in effect).
In my opinion, founders should always draft vesting agreements when the company is incorporated (for a multitude of reasons). This has an important benefit of giving them the opportunity to file their 83b election within the 30-day window. This significantly lowers the risk that they find themselves owing tax as shares vest if they are required to accept vesting agreements in the future.
- Early option exercise plans. Some option plans allow employees to exercise their options prior to vesting. This provides the employees the tax advantage of starting the clock on long-term capital gains early. Once the options are exercised, they typically become subject to a stock restriction agreement and the employees would need to file an 83B after they exercise.
How to make an 83B election
The IRS doesn’t provide a form for the 83B election, but the process is straightforward. From IRS publication 525:
How to make the choice. You make the choice by filing a written statement with the Internal Revenue Service Center where you file your return. You must file this statement no later than 30 days after the date the property was transferred. A copy of the statement must be attached to your tax return for the year the property was transferred. You also must give a copy of this statement to the person for whom you performed the services and, if someone other than you received the property, to that person.You must sign the statement and indicate on it that you are making the choice under section 83(b) of the Internal Revenue Code. The statement must contain all of the following information.
- Your name, address, and taxpayer identification number.
- A description of each property for which you are making the choice.
- The date or dates on which the property was transferred and the tax year for which you are making the choice.
- The nature of any restrictions on the property.
- The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice.
- Any amount that you paid for the property.
- A statement that you have provided copies to the appropriate persons.
The form we used to file our 83B elections at BrandVerity is here. Most lawyers will recommend that this notice be sent via certified mail.
Disclaimer: I am not a lawyer, tax accountant or otherwise qualified to dispense with legal and/or tax advice. You should always consult with a qualified professional before making decisions regarding Section 83b and/or your stock plans.
Dave,
Great post and on an issue that all founders encounter but is rarely talked about.
Any thoughts on whether founders should start a company with just say 10 shares (unrestricted) issued. And then, when they take in financing, issuing more as restricted stock (which can be covered by and 83b election, even though the initial shares are not.)
I know you can't give legal advice, but curious about your thoughts.
Rahul
I suppose that would make sense if you are going to follow an
incorporation with an immediate funding event. I believe that it is
more difficult to grant additional stock in some states.
I'd generally argue that founders should be on vesting schedules
regardless of how far off a funding event is – it is hugely important
should something go awry in the relationship.
Actually, you make a great point Dave. What I suggested would really not work since founder shares are typically quite a bit cheaper than shares issued in any funding event. Thanks for the clarification.
Right, good clarification. If the two events (incorporation & funding)
are separated by good progress made by the company, FMV of the shares
will increase substantially and cost the founder's more to buy their
restricted stock (or instead ISO options could be granted).
If founders take unrestricted stock in exchange for cash or property, no gain or loss is recognized, according to IRC Section 351. But if founders take restricted stock in exchange for the same cash or property, does this fact alone create a Section 83 transaction? I.e., is the fact that there is vesting enough to make this a stock-for-services transaction? Do founders then have to file an 83(b) election to be taxed at the time of contribution on the difference between the FMV of the stock received and their basis in the property contributed?
Pato,
You are correct. If the founder's take unrestricted stock, in exchange
for cash or property at FMV, they own the stock outright and do not
have to pay taxes. If for some reason they buy the stock at a price
below FMV, they then need to pay ordinary income tax on the difference
between FMV and the current value (I believe the IRS would then
consider it a stock-for-services transaction).
The restrictions on the stock inevitably look much more like a
stock-for-services transaction. If it was stock-for-cash transaction
the restrictions would be unnecessary. Yes, they need to file the 83b
to be taxed on the first purchase and not when the restrictions lift.
If they buy the stock at FMV, they then owe no tax at purchase or at
vest if they file their 83b within the 30-day window.
Keep in mind that if the founders raise capital, the investors will
demand that the founder's put restrictions on their formerly
unrestricted stock. The founders may not be able to file an 83b
anymore and they could end up paying loads of taxes as the company
increases in value and their restrictions lift.
Dave – in the situation where founders stock is originally issued with no vesting and then vesting is imposed by VCs in connection with a venture financing, no 83(b) filings are necessary in this case. The rev ruling is very clear on the subject, so I think that attorneys that have alternative views simply don't realize that this ruling exists. In the past, many attorneys counseled founders to make an 83(b) filing just in case in this situation, but this is no longer necessary. Thus, I think your comments above are somewhat misleading that "[c]reating stock vesting agreements after the 30-day 83B window is tricky."
Please let me know what you find. I'd love to be wrong on this.
While the advice wasn't from Wilson, it was from an established and
reputable firm that focuses on startups.
Thanks for taking the time to engage on this.
Yokum, this is exactly the point that I've received completely
different legal interpretations on (which I did mention above).
Ultimately, one of the two legal interpretations is correct – I'm
simply arguing to take the more conservative approach.
My (limited) understanding of the law is that the law isn't clear.
The ruling refers to 'substantially vested stock' becoming
'substantially unvested'. However, the presumption in that ruling
appears to be that the stock was formerly subject to section 83 (ie it
was granted under a stock-for-services agreement). Most unrestricted
founder stock transactions are outright purchases and aren't subject
to section 83 because they are stock-for-cash transactions. As soon
as the restrictions are placed on the stock it falls under section 83
and may or may not be eligible for an 83b filing.
Some lawyers read the ruling and believe it handles the scenario you
mention (rather than the scenario where a vesting agreement is
modified). Others disagree.
I don't know how the IRS has audited these transactions, and I'm very
willing to admit that the conservative approach may not be necessary.
But, given the conflicting legal guidance I've gotten and what I've
been able to gather from the ruling, it seems prudent to assign
restrictions to founders at initial grant & then file the 83b. If you
have experience otherwise, I(we) would love to learn about it.
Hmm … not sure where the advice is coming from … I hope it's not any of my colleagues. I think that the suggestion to always place restrictions on founders stock at initial issuance to be an extreme and unnecessary position. I have never heard that advice before and I would be surprised to hear it from a reputable law firm. Even prior to the ruling, the conventional wisdom was that 83(b) filings were not necessary in the event of vesting of previously fully-vested stock in connection with a venture financing. I'll make a point to quiz some of my tax and employee benefits colleagues to double check as I believe the conservative position that you explain above is simply incorrect. At the end of the day, the corporate attorneys (like me) really defer to the tax and employee benefits specialists on any difficult 83(b) issues and I didn't think that there was even debate on this issue.
In mid 2005 I sold 3 companies. I company was a S corp and the other 2 were C corps. The S Corp held the rights for 7 applications to a patent I personally owned the patent.. One c corp was a marketing entity for 7 applications pertaining to this patent. The final C corp held the manufacturing rights to make the product for the 7 applications. I sold these 3 companies for cash and 18 million shares of restricted stock of the company that bought out these 7 applications. This others companies stock was trading at 3.70 on the day the sale closed. Wha twere my tax obligation for this deal?????????
Sorry, this is out of my league. I highly recommend you connect with a tax lawyer.
Yokum,
For some reason the URL got clipped. Could you resend or edit?
Thanks!
Dave
Can an "ENTITY" (not a person) make an 83(b) election?
Sorry, this is out of my league =).
Dave
Can a director make an 83(b) election?
Yes. My understanding is that it is independent of role.
[...] A good explanation on 83b elections [...]
I'm not a tax lawyer, etc. This is something you'll want to run bysomeone who is much more qualified than myself…My understanding is that you have to file an 83b the moment youreceive the full grant. The type of vesting used on stock grants istypically the reverse vesting of the company's right to repurchase thestock. So, you own the stock right at the grant – and as your timethere increases, the company's right to repurchase the stock lifts.