An 83(b) election accelerates your tax obligation, so you pay tax sooner on the value of the stock at grant rather than its value when it vests. Accelerating your tax obligation may sound like a bad idea, and sometimes, it is: for example, if you think the stock will become worthless or drop in value, you should probably not accelerate your tax obligation. In addition, if the stock being issued to you is worth a significant amount of money, you will immediately owe taxes on that issuance. For example, if you are granted $100,000 of restricted stock and file an 83(b) election, you could owe $35,000 to the government (assuming a tax rate of 35%).
While there are certain cases in which accelerating a tax obligation isn’t advantageous, these cases rarely apply to founders. This is because a founder’s obligation may be very little now, but could become much higher later. When founders file an 83(b), they may save taxes, effectively defer tax obligations, and begin the clock used to determine whether or not your gain was long-term or short-term.
When you (as a founder) file an 83(b), tax savings occur because you move more income from the “ordinary income” tax classification to long-term capital gains, which can be taxed 10-20% less than ordinary income, depending on your tax bracket.
Deferring taxes prevents you from being taxed on income you earn, but for which you do not receive cash consideration. This is because as stock vests over time you earn a piece of paper with paper value. But you do not receive cash consideration for it. However, the IRS ignores whether or not you receive the cash and requires you to pay taxes on it.
Long-term capital gains rates are applied to gains on investments held for longer than a year. Anything sold before that is subject to short-term capital gains tax, which is effectively equivalent to the ordinary income rate. If something can tilt the advantage of paying lower taxes in your favor, you want that advantage.
Conceptually, this makes sense. But it may help to look at it mathematically.
Example 1: successful exit with 83(b)
Let’s say in January 2017, a founder starts a company and grants herself 5,000,000 shares at $0.001 per share, vesting over four years.
At this point, the founder has no idea what the future price per share will be. But we can calculate her tax liability if she files an 83(b) since we know the par value at issuance, the amount of stock granted, and the tax rate. Let’s see how:
If the grant amount is 5,000,000 shares, and each is worth $0.001, then the grant is worth $5,000 (= 5,000,000 grants * $0.001).
If a grant is worth $5,000, how much tax would she owe? First, she needs to consider how much she paid for her grants, which is also known as her cost or tax basis. Since these grants were given to her, she paid nothing, which means her tax basis is nothing. To determine her taxable income, she must subtract her tax basis ($0) from the income received ($5,000). This yields a taxable income of $5,000.
Next, she needs to know the type of tax rate to which that $5,000 of income is subject. Since she filed an 83(b), she elects to pay her ordinary income rate, which can be found on the IRS tax tables. For now, let’s assume it’s 35%. Therefore, she will owe $1,750 (= 35% * $5,000).
Filing an 83(b) election right now will cause an immediate tax obligation of $1,750. Not filing one will not cause a tax liability.
Now let’s say that in year five, her company is sold at $7.00 per share and her stock is worth $35,000,000.
In this case, her net proceeds equal $27,999,250, almost 80% of the sale price. It’s important to note that the amount of taxable income subject to the lower capital gains rate is almost the entire sale price of $35,000,000, and the amount subject to the higher ordinary gains rate is relatively insignificant.
Example 2: successful exit without 83(b)
How does this scenario unfold if no 83(b) election is filed? To begin, our founder does not claim any income, so there is no immediate tax obligation (compared to a tax obligation of $1,750 existed if she filed an 83(b) election).
Now let’s assume that the price per share increases by $1.00 each year as her stock vests well before the exit event. If that’s the case, then anything that vests will be taxed at the ordinary income rate, since according to the IRS, property has been transferred.
At the end of year one, our founder will owe $437,938 in taxes since $1,251,250 of income was transferred to her for services performed. In year two, $875,438 will be owed in taxes, and so on.
In year five, when her company is sold for $7.00 per share (just like in our other example) she will have accrued a significant tax basis, which reduces her capital gains, but does so at the expense of paying a higher ordinary income rate during the vesting years.
In this scenario, by not filing an 83(b) election, our founder would have paid an additional $1,875,000 in taxes. More importantly, she would have created significant cash flow issues due to the timing of the tax liabilities that came due when vesting occurred.
Ultimately, the 83(b) election is well aligned with the reason you are starting a company: to create and capture value. An 83(b) election may allow you to capture more value if there is a successful outcome. As shareholder value rises, so do tax savings if you file an 83(b) election. The tax liability created by filing an 83(b) is greatest for those who receive stock that is worth a significant amount of value, but founders shouldn’t worry about their initial grants, since the stock you are issuing is not worth much… yet. Under these circumstances, it usually makes sense to file an 83(b) election when you found a high-growth startup. Look at the situation in reverse: if you didn’t think a startup would be successful, why be a founder or buy shares in the first place?
Some final points to note:
- The burden of proof that you filed an 83(b) election is on you. Assume that it will go missing. Therefore, it’s highly advised that you mail certified return receipt requested.
- If you purchased/received founders stock with restrictions, such as vesting, you should file an 83(b) most of the time.
- If you purchased/received founders stock with no restrictions such as vesting, you do not file an 83(b). This is because there is no risk of forfeiture; the stock was already transferred to you.
- If you were granted restricted stock in an early stage company, you should file an 83(b) most of the time.
- If you have stock options, you do not file an 83(b) unless you have an early exercise option.
- You only have 30 calendar days from the stock grant date to file an 83(b), so don’t wait!
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.