§83(b) Election and §83(a)
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Authored by Bryan Springmeyer Bryan Springmeyer is a California corporate attorney who represents startup companies. The information on this page should not be construed as legal advice. |
To start, §83(a) requires tax payers to report as income property which is transferred to them for their services. The calculation of income is the fair market value ("FMV") of the property minus any amount that the recipient paid for it. This rule applies when stock is given to an employee as part of their compensation. If the stock is vested, its value minus anything the recipient pays for it is immediately recognized as income. Transactions involving stock issuances to founders of startups are often structured to reflect the nominal value of the new company, so the founders do not pay income tax on the receipt of stock.
Not all grants involve vested stock. Stock which is issued subject to the company's repurchase right is referred to as “restricted stock”. At formation or during venture capital transactions, the founders will often enter agreements which grant the company the right to repurchase a portion of the founder's stock if the founder leaves the copmany prior to the term of vesting, which is typically four years. Once the founder has remained with the company for certain increments of time during the vesting period, the stock becomes free from the contractual repurchase right of the company, and is thus vested. Restricted stock does not trigger §83(a) until it vests. At that point, absent a §83(b) election, the holder recognizes the income and is subject to income tax.
For example:
Mark is a founder and developer at a startup Web App company and receives 2,000,000 shares of stock on a four year vesting schedule with a one year cliff. Mark did not assign any intellectual property to the company upon startup or make any capital contributions. Additionally, he did not send an 83(b) election letter to the IRS. He does not recognize any income until year one, when 25% of his shares are free from the repurchase option of the company and no longer subject to any restrictions. At that time, he must recognize income for the FMV of 500,000 shares of stock, even though he has not received anything new. Each month thereafer, Mark must recognize income for the FMV of 41,666 shares of stock, even if he never sells a single share.
A §83(b) election allows the holder to elect to recognize the income at the point when the restricted stock is granted, rather than upon vesting. This would work well if the stock was not worth much and the holder had the funds to purchase the stock at its FMV or pay income tax on the FMV. It would work especially well if that stock increased in value over the vesting period, because: 1) the increase in value could constitute capital gain, rather than ordinary income because the capital gains tax for long-term investments (over one year) is lower than ordinary income; and 2) the tax for the increased value would not become due until the stock was liquidated, ensuring the taxpayer has the cash to pay their tax obligation.
Stated conversly, failure to make an 83(b) election could be very burdensome for a stockholder who doesn't have the liquid assets to pay the income tax on the vesting shares. It could be horrific if the company's value swelled, subjecting the founder to income tax on millions of dollars of income (without ever receiving cash for that income) and then the value of the shares dropped before the holder could liquidate.
A §83(b) election is a simple letter written to the IRS notifying them that you are electing to recognize income now.