If you're reading this, chances are this is not the first time you've heard of the 83(b) election (and if it is, then definitely keep reading). The "83" in "83(b) election" refers to Section 83 of the Internal Revenue Code, and despite the relative simplicity of the concepts that this particular section deals with, the 83(b) election may be one of the most important tax filings you make while on your startup journey.
TL;DR: If you acquire shares of a corporation's stock, and the stock is subject to vesting, youshould strongly consider making an 83(b) election to optimize the tax treatment of your stock, keeping in mind that the IRS has a strict 30-day filing window from the date of acquisition.
To fully appreciate the significance of the 83(b) election, let's take a step back and focus momentarily on Section 83(a) of the tax code.
Section 83(a) says, in a nutshell, if you receive property as compensation for services, and that property is "subject to a substantial risk of forfeiture," the general rule is that you will owe taxes to the IRS at the time this risk goes away on the delta between (1) the fair market value (FMV) at such time and (2) the amount originally paid, if any.
To illustrate this with a more familiar scenario, suppose you acquire shares of stock in a startup at $0.01 per share and the shares are subject to a four-year monthly vesting schedule, with vesting to start immediately upon acquisition.
These shares would be subject to forfeiture for purposes of 83(a) until they vest because if you were to leave the company before the vesting schedule is completed, any unvested shares would be subject to repurchase by the company, and you would walk away with any vested portion. Put another way, when your shares vest and become yours to keep, they are no longer at a "substantial risk of forfeiture," and the IRS views this as a taxable event, triggering the IRS's general rule.
Therefore, if your stock is subject to a four-year monthly vesting schedule, the IRS's general rule says that you must report any increase in value to the stock at each vesting increment, as each is considered a taxable event. This means you would have to figure out what the stock is worth at 48 separate time points (every month over four years), then report those gains as income on your tax returns even though you won't have received any liquid assets from which to pay those taxes. And, of course, if you go on to sell your shares, you will owe taxes on that sale as well.
In short, if you do not make an 83(b) election, you will be incurring tax liability at every vesting increment AND upon ultimate sale.
Thankfully, the tax code provides an alternative to this somewhat maddening framework; enter the 83(b) election. Section 83(b) allows you to make an election to be taxed on all your shares up front, even those that are unvested, in the tax-year you acquire them. The tax is based on the spread between (1) the fair market value (FMV) at such time and (2) the amount originally paid, if any; in many cases, for founders, that spread is nonexistent, meaning no taxes at that time. After making this election, the IRS will no longer treat vesting increments as taxable events, and, ordinarily, the only subsequent taxable event would occur upon selling the shares. If the company ends up being wildly successful, the tax savings could be significant. Note that the IRS only allows you to make this election within 30 days of acquiring the shares—no exceptions whatsoever.
Of course, if you decide to make an 83(b) election but leave your company before the stock vests, you don't get to recoup any amounts previously paid to Uncle Sam. This is not a big deal when the stock is valued at fractions of a penny, or if you paid the fair market value for your shares in the first instance, but if you received the shares without paying and the valuation wasn't super low, you might feel the sting a bit more.
But what about stock options? Well, the IRS does not view stock options as "property" for these purposes, so neither Section 83(a) nor (b) would apply, even if your option grant is subject to a vesting schedule.
Note, however, thatif an option is early-exercisable and unvested shares are in fact exercised, then you're back in the scenario described above regarding stock, and the vesting of those shares would trigger the IRS's general rule of making you pay taxes at each vesting increment, unless, of course, you make an 83(b) election within 30 days of the early exercise. The company should actively monitor any exercises if it allows early-exercisable options and follow up with those exercising to make sure appropriate steps are being taken.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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