One of the most common mistakes founders, employees and investors make is failing to make an 83(b) election when receiving restricted stock. We will focus on founders, but the premise remains the same for employees and investors alike.
Founders typically purchase stock pursuant to restricted stock purchase agreements or similar agreements which contain restrictions on the stock, with the shares either vesting over time, or the issuer having a right to repurchase the shares at the sale price which expires over time. As an example, under a typical vesting or repurchase expiration schedule, the stock vests over a four year period, with a one year cliff. This means a founder would own 25% of their stock free and clear after year one, and another 25% of their original stock grant would similarly become owned free and clear of any restrictions on each subsequent year.
83(b) refers to a special tax election a founder may make with the IRS to notify the tax authority that they have purchased stock that has not yet vested or has restrictions on ownership, but that they would like to recognize the income associated with the ownership of the stock immediately. An 83(b) election would also start the holding period used in determining long term capital gains treatment. If a founder chooses not to make an 83(b) election, the founder would not recognize income (the difference between fair market value on the day the shares become owned free and clear, and the price paid) until the stock vests or the restriction lapses. Additionally, the holding period for determining long term capital gains treatment would not begin until the shares have vested. Failing to make a timely 83(b) election with the IRS can lead to substantial tax liability when the stock vests or the restriction lapses.
Often the purchase price of the stock and the fair market value of the stock on the purchase date is de minimis. If a founder makes an 83(b) election on the purchase date the founder would often not have any taxable income to recognize, and the vesting dates or dates upon which the repurchase right lapses would no longer be taxable events. However, if a founder fails to make a timely 83(b) election, the stock’s fair market value may increase and the founder would then realize substantial taxable liability upon the vesting date based on the increase in value – even if the founder does not sell the stock and therefor does not have the liquidity to pay the tax bill.
As an example, assume two founders each receive 1,000,000 shares of stock for the purchase price of $10.00 on the day the company is formed. Because the two partners want to give each other incentive to be fully engaged in the company for at least 4 years, they agree to a repurchase right for the company that lapses as set forth above. The first founder makes an 83(b) election and the second chooses not to. Because the shares have no value on the day the company was formed, the 83(b) election would not create an additional tax burden on the first founder in year 1, and when the repurchase right lapses, because the election has been made, the lapse of the restriction over the next four years would not be a taxable event – instead, the first founder would not report any income on the shares until they were sold, at which time the founder would presumably be in a better position to pay the tax bill, and may be taxed at the lower capital gains rate as opposed to the income tax rate. The second founder is in a much pricklier situation. If we have the imaginary company grow to a $1,000,000 valuation in year one, and then double each year thereafter, and assume the two founders remain 50-50 owners of the enterprise, the second founder would be imputed $125,000 of income upon the first restriction expiration date; $250,000 on the second, $500,000 on the third and $1,000,000 on the fourth. In each case, the math is (x) 25% of 1,000,000 shares becoming owned free and clear (250,000 shares), divided by (y) 2,000,000 shares outstanding times (z) the company’s valuation. Not only would the second founder have to eat the tax bill on each of these years without a liquidity event to fund the payment, but the shares may be imputed at the higher income tax rate as opposed to getting capital gains treatment.
In order to make an 83(b) election a founder simply needs to fill out a form and send it to the IRS. The form is generally provided to the founder by the company and accompanies the restricted stock purchase agreement (or similar documentation). An 83(b) election must be made no later than 30 days after the purchase date of the stock. This is a strict deadline and there are no exceptions!
Whether a founder should file an 83(b) election is complicated and facts sensitive. This blog post is not intended to provide legal or tax advice. Founders, employees and investors should consult a tax advisor and legal counsel to discuss the facts and circumstances of their particular situation.