Section 83(b) Elections: What are They and Why Should You Make One?
Many startup founders and employees have heard about Section 83(b) elections but do not understand what a Section 83(b) election is or why it is important. This article provides some needed background to understand this device that can save you money on your taxes.
The default federal tax rule is that equity grants are taxed at the time of vesting. This means that if your equity vests quarterly over a four-year period, you will be taxed on the value of the equity that vests every three months as if you received that equity as regular income. Not only does this create an accounting nightmare, but it can also incur a large tax bill at a time when you as a founder or employee do not have cash to pay the taxes. A Section 83(b) election is a letter that a startup founder sends to the IRS telling the IRS to tax the founder or employee at the time the equity is granted rather than when the equity vests.
Since federal income tax is based on the fair market value of the equity received, without filing a Section 83(b) election you will pay more in federal income tax for shares as they vest if the value of your company increases. This can result in significant amounts of additional taxation, as illustrated by the simplified (i.e. taxes other than income and long-term capital gains are excluded) example below:
A founder receives 100,000 shares subject to vesting with a par value (and assigned value) of $0.01 that are worth $2.00 per share when they vest and are worth $10.00 per share when sold more than one year later. The founder pays the maximum federal income tax rate of 37%. If the founder does not file a Section 83(b) election, the founder will pay $74,000 ($200,000 x 37%) in federal income tax when the stock vests. When the stock is sold for $10.00 per share, the founder will realize a taxable gain of $8.00 per share or $800,000, which is taxed at the long-term capital gains rate of 20%. This means the founder will pay $160,000 in taxes at the time of sale and will have a total economic gain of $766,000.
Had the hypothetical founder filed a Section 83(b) election instead, then the shares will be treated as income when granted for tax purposes, meaning the founder would have paid ordinary income tax of $370 since the shares were worth $1,000 when the stock grant took place. There is no additional income tax when the stock vests. When the stock is sold for $10.00 per share, the founder will realize a taxable gain of $9.99 per share or $999,000, which is taxed at the long-term capital gains rate of 20%. This means the founder will pay $199,800 in taxes at the time of sale and will have a total economic gain of $799,830. So in this simplified example, by filing a Section 83(b) election our hypothetical founder would save $33,830 in taxes.
There are situations where filing a Section 83(b) election may not be the best decision. If the amount of reported income is substantial when the restricted stock is granted so that paying income taxes then would cause financial difficulties or if you intend to leave a company before the vesting period is over then you may decide not to file a Section 83(b) election. This depends on your individual circumstances.
There are technical requirements for submitting a Section 83(b) election with the IRS, but the most important is that you only have thirty (30) days to file a Section 83(b) election. If you wish to discuss whether filing a Section 83(b) election makes sense for you or if you wish to discuss the mechanics of filing a Section 83(b) election, email us at firstname.lastname@example.org and we will work through your specific situation.