Missing the 83(b) Deadline Can Spell Disaster for Founders
This write-up was originally sent to subscribers as a part of our Mission Control weekly insights, a series where we share wisdom and quick breakdowns on topics from our entrepreneur support network. Sign up for those here.
When you receive a stock grant in a startup that has a vesting schedule, the IRS taxes it in a way that can be very disadvantageous to founders and early team members. Luckily, there’s a straightforward way to change this—file an 83(b) election—but you’re on the clock so don’t miss it.
TLDR: For most founders and early team members who receive vesting stock grants, filing the 83(b) is a no brainer. Do not ignore it or neglect it! You have 30 days after the date of the stock grant to file it. If you miss the deadline, it’s tricky to fix it. You’ll probably need a lawyer, pay fees, and jump through some annoying process hoops. This is why all grants done in Gust Launch have 83(b) pre-filled templates, reminders, and step by step guides so founders don’t mess it up.
What is the 83(b) election?
Founders and early team members usually receive vesting stock grants of common stock, also referred to as restricted stock awards. When these grants are made, the grantee immediately owns all of the shares and continues to own all of them until the vesting ends or their relationship with the company ends. If their relationship with the company ends, the vesting provisions allow the company to automatically repurchase all of the unvested shares (if any). This arrangement allows startups to fairly incentivize founders and team members over the course of their time with the company, without risking accumulating dead equity on the cap table should someone leave early.
The IRS considers the automatic repurchase right of the vesting provisions a “substantial risk of forfeiture”. In other words, there’s a real risk that the company can take back shares from the grantee until those shares are vested.
Because of the risk, by default, the IRS does not recognize the shares as ordinary income until they have vested. When the IRS recognizes shares as ordinary income, the amount of income is determined by taking the difference between the current value of the shares and the original purchase price.
Startups are designed to grow fast and vesting is typically over 4 to 6 years. When a founder is recognizing ordinary income in year 3 or 4 of the vesting schedule it’s very likely the the current value of the shares is much, much more than the original purchase price. This results in a large income tax liability on shares that can’t be turned into cash. Imagine if you’re vesting 100,000+ shares a month at a value even $0.50 more than what you purchased them for.
Ownership in a company is the most important incentive for founders and early team members. It’s the primary mechanism by which they achieve life changing financial outcomes in exchange for the financial sacrifices they make to build a great business. When ownership turns from a future—hard earned—payday to an immediate cash liability that incentive evaporates, spelling trouble for the startup and its investors.
Gust's New Corporate Diligence Review Tool can identify preventable corporate structure issues that come up in diligence, and help guide founders towards fixing them.
Why do startups vest stock then?
So, why do restricted stock grants have vesting at all if it introduces income tax complexity? Vesting allows startups (and their investors) to incentivize team members over the multitude of years it will take to build a big business. It allows the startup to concentrate ownership in the people who are actively contributing to the business—if a team member leaves they don’t get ownership credit for a future they’re no longer participating in.
Since vesting is necessary to align incentives over the long haul and protect the company, we need a way to mitigate the potentially disastrous income tax consequences. That’s where the 83(b) election comes in. The 83(b) election allows a grantee to elect to recognize all of the ordinary income associated with a stock grant in the year that the grant is made. For most founders and early team members that means $0 in ordinary income if they don’t miss the 30 day filing window.
A fair grant of ownership with a vesting schedule that matches the intended duration of the relationship and an appropriately filed 83(b) election protects and rewards all parties no matter what the future holds.
This is considered a “startup best practice” that founders may overlook. We created Mission Control to support founders and remind them of things like this.
Startups often struggle by considering themselves a special case and forgoing—or forgetting—standard best practices like vesting and 83(b) elections. Mission Control serves as a regular pulse check to reify and remind founders and their team of the little things with big consequences. We’ve helped thousands of founders navigate their vesting schedules and 83(b) elections with software, templates and humans support.
Additionally, if you want to see how missed 83(b) elections and other “gotchas” can impact your corporate history—and how to fix them—check out our free Corporate Diligence Report.
Gust's New Corporate Diligence Review Tool can identify preventable corporate structure issues that come up in diligence, and help guide founders towards fixing them.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.