By: Jon Avidor
Imagine you’re at a cocktail party with a circle of sophisticated, seasoned startup investors and you get caught in a conversation about 83(b) elections, finding yourself completely out of your depth. What you do next is critical: First, get out of there. Nobody deserves to be subjected to party conversation about tax law. Ever. Second, let a lawyer explain to you what in the world 83(b) is, and why you might want to consider making the election and making it on time so that you can avoid an unnecessarily high tax bill.
The federal government taxes the value of any property a person receives in connection with the performance of services as part of the that person’s gross taxable income. If the property consists of shares of stock that are subject to vesting (meaning the company has a right to repurchase all or a portion of the stock under certain circumstances, such as your departure from the company) then you have the ability to choose when it’s taxed. If you don’t file an 83(b) election, you’ll be taxed at the time the stock vests, and the income on which you’ll be taxed is the difference between what you paid and the value of the stock at the time it vests).
By making an 83(b) election (a reference to Section 83, subsection (b) of the Internal Revenue Code, 26 U.S.C. § 83(b)), you are effectively asking the IRS to accelerate your tax, and to tax you at the time of grant, not when it vests.
Why Make the 83(b) Election
A taxpayer would be inclined to make an 83(b) election if she suspects that the value of the property will increase over time such that taxing the value of the property at the time of the grant, when it’s worth less, will alleviate a greater tax burden when her property rights fully vest later. This is commonly the case with early-stage companies. Consider the following scenario:
You are approached by the founders of a startup that has just gone through its first seed financing round with an offer to become the company’s new chief executive officer. The founders offer you a competitive compensation package, which includes 10,000 shares of stock at a price of $0.001 per share for an aggregate purchase price of $10.00. However, the stock is subject to a two-year vesting schedule and a right of repurchase on all unvested shares. You accept knowing that you will be taxed on the difference between the stock’s purchase price and fair market value. You must now decide whether you want to be taxed at the time the shares are purchased (when the fair market value is $0.001 per share), or when the right of repurchase lapses and the shares are fully vested two years from now, presumably when you have increased the company’s value, and the fair market value of its shares, as its CEO.
It is often a good idea to file the 83(b) election soon after receiving value that could someday increase in value. This way, you will pay less in taxes if the potentially valuable asset actually realizes that value.
How to Make an 83(b) Election
Any transferee should consult with her professional tax advisor before making any decisions regarding whether or not to make an 83(b) election. It is in each transferee’s sole discretion whether to make an 83(b) election, and as such, it is that taxpayer’s sole responsibility to submit this notice to the Department of the Treasury. However, be aware that a transferee has a small window of time, within thirty days of the award date to be exact, in which to make the 83(b) election, so she should not delay this decision for long.
To make the election, the taxpayer sends a letter to the IRS that contains information about the taxpayer, the property and transfer for which the election is being made, any restrictions on the property, the amount paid for the property and its fair market value, among other things, as required by Treasury Regulations, 26 C.F.R. § 1.83-2(e). In addition, the taxpayer must also provide a copy of the 83(b) election notification to the transferor (commonly, the corporation).