83(b) Elections: Startup Tax Issues (Part 2)
In Part I of our Startup Tax Issues series, we discussed how to avoid penalties with valuations. But what about issues related to 83(b) elections? Startup founders or other service providers receiving restricted stock should strongly consider making an 83(b) election in the year the restricted stock is granted. The election typically results in minimal additional taxation within the year. But you could also avoid substantial taxes in future years.
What is 83(b) Election?
A service provider makes an 83(b) election to recognize current income on equity compensation received for services subject to vesting or similar restrictions. For startups, 83(b) elections usually arise in the context of restricted stock purchased by a founder. These tax elections are subject to vesting restrictions. These restrictions typically allow the company to repurchase the unvested stock at the purchase price if the service provider stops working.
With 83(b) election, a service provider recognizes income in the current year equal to the amount of the excess of (i) the fair market value of the stock over (ii) the amount, if any, paid for the stock. This frequently results in little or no tax to the service provider in the current year. This is due to the purchase price usually being equal to the stock’s fair market value at the time of grant. As to future years, however, the election potentially saves the service provider from significant additional taxes.
Usually, each vesting event would result in a tax on the amount of the newly-vested stock’s fair market value over the purchase price (if any) paid for that stock. As you may know, startup company common stock frequently appreciates significantly over time. In the absence of the 83(b) election, the service provider could incur significant additional taxes as the vesting events occur.
Example of 83(b) Elections
A founder purchases 100,000 shares of restricted stock from her company. Its fair market value is $0.001 per share, for a total purchase price of $100. The restricted stock vests in 25,000 share increments over the next four years. Over time, the company grows. In year two, the stock is worth $.01 per share. By year three, it is worth $1 per share. In year four, it is worth $10 per share. In year five, the company was purchased by a large competitor at $20 per share. The founder receives $2,000,000 in cash.
In scenario one, the founder promptly files her 83(b) election in year 1. Since the shares are worth $0, and because she paid $0 for them, she will have no tax in year one and will not pay taxes upon each vesting event. When she receives the cash consideration upon an exit, she will recognize $1,999,900 in capital gain income. This amount is the difference between her $100 “basis” in the shares and the consideration she received.
In scenario two, if the founder fails to file her 83(b) election. She again recognizes no tax in year one. In year two, however, when the first 25,000 shares vest, she recognizes $225 in income. That is, the $250 fair market value minus the $25 basis allocable to those vested shares. In year three, she recognized $2,475 in income ($2,500 minus $25). In year four, she recognized $24,975 in income ($25,000 minus $25).
Finally, in year five, she recognizes $249,975 in income ($250,000 minus $25). Note that all of these amounts will be “ordinary” income and taxed at normal income tax rates. The aggregate ordinary income will be $277,650. Upon purchasing the company in year six, the founder will recognize $1,722,250 in capital gains.
83(b) Elections Have Big Benefits
This example illustrates an additional benefit of the 83(b) election. With an election, future gains will be capital in nature and likely subject to a lower tax rate. Without the election, each vesting event will lead to ordinary income, which is frequently subject to a higher tax rate. For instance, if the long-term capital gain tax rate is 15%, our hypothetical founder’s ordinary marginal income tax rate is 28%. Assuming that the company is purchased more than one year after the final vesting event in year five, our founder pays more than $36,000 in additional tax in the scenario in which she fails to make her 83(b) election.
One important thing to note is that 83(b) elections must be made within 30 days of the date of grant of restricted stock.
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TO ENSURE COMPLIANCE WITH REQUIREMENTS IMPOSED BY THE IRS, WE INFORM YOU THAT ANY U.S. FEDERAL TAX ADVICE CONTAINED IN THIS DOCUMENT IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, FOR THE PURPOSE OF (I) AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE; OR (II) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY TRANSACTION OR MATTER ADDRESSED HEREIN.
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