Startup Tax Issues (Part 2):
Founders or other service providers receiving restricted stock should strongly consider making an 83(b) election in the year the restricted stock is granted. This election normally results in minimal additional taxation in the year it is made, but could avoid substantial taxes in future years.
An 83(b) election is an election made by a service provider to recognize current income on equity compensation received for services that is subject to vesting or similar restrictions. For startups, 83(b) elections usually arise in the context of restricted stock. Restricted stock is stock that is normally purchased by a founder (or possibly another service provider), and is subject to vesting restrictions. The vesting restrictions usually allow the company to repurchase the unvested stock at the purchase price if the service provider stops working for the company.
An 83(b) election results in a service provider recognizing 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 as the purchase price is usually equal to the fair market value of the stock at the time of grant. As to future years, however, the election potentially saves the service provider from significant additional taxes. Normally, each vesting event would result in tax in the amount of the fair market value of the newly-vested stock over the purchase price (if any) paid for that stock. Since 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.
Here is a simple example demonstrating the importance of an 83(b) election:
A founder purchases 100,000 shares of restricted stock from her company at its fair market value of $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. In year three, it is worth $1 per share. In year four, it is worth $10 per share. In year five, the company is purchased by a large competitor at $20 per share, and 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 1, and will not be taxed upon each vesting event. When she receives the cash consideration upon an exit, she will recognize $1,999,900 in capital gain income (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 recognizes $2,475 in income ($2,500 minus $25). In year four, she recognizes $24,975 in income ($25,000 minus $25). Finally, in year five, she recognizes $249,975 in income ($250,000 minus $25). Note, all of these amounts will be “ordinary” income and will be taxed at normal income tax rates. The aggregate ordinary income will be $277,650. Upon the purchase of the company in year six, the founder will recognize $1,722,250 in capital gains.
This example illustrates an additional benefit of the 83(b) election: if the election is made, future gains will be capital in nature, and likely subject to a lower rate of tax. If the election is not made, each vesting event will lead to ordinary income, which is frequently subject to a higher rate of tax. For instance, if the long-term capital gain tax rate is 15%, our hypothetical founder’s ordinary marginal income tax rate is 28%, and assuming for the sake of simplicity that the purchase of the company occurred 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.