When you are transferred stock in your startup that is subject to vesting or exercise a stock option prior to vesting (a so-called “early-exercise” stock option), you have a 30-day window to file an 83(b) election with the IRS. This election allows you to pay income taxes upfront based on the difference between the fair market value (FMV) of the shares at the time they are transferred and the price you paid. Typically, founders who acquire stock at incorporation pay a nominal price and face no immediate tax if the FMV equals their purchase price. Let's compare the outcomes associated with vesting using the below examples, assuming that you are the sole founder and the par value is equal to the FMV on the date of transfer.
With an 83(b) Election: $0
If you elect to file an 83(b) right after receiving your 8 million shares priced at $0.00001 each, totaling $80, and the FMV at that time is also $0.00001 per share, your tax liability would be minimal or nonexistent because the FMV matches your purchase price.
This strategic decision allows you to lock in the FMV at grant, meaning any future appreciation in the stock's value due to company growth will not increase your tax burden under this election.
Future sales of these shares would then be subject to capital gains tax (long or short-term, depending on the length of your holding period), which could be lower than the ordinary income tax rate.
Without an 83(b) Election: $1,850,000
Suppose you do not make an 83(b) election; then you will pay the ordinary tax rate on the vested shares. If your share value increases to $8M four years later (with the FMV of each share increasing to $1), here’s how your tax liability would unfold, assuming the highest tax bracket of 37% (for simplicity’s sake, we have assumed no penalties or state/local taxes apply), that the FMV of the shares increases each year and the shares vest evenly over four years:
- Year 1 Vesting: 2 million shares vest at an FMV of $0.25 per share (2,000,000 shares x $0.25 = $500,000 FMV).
- Tax at 37% = $500,000 * 37% = $185,000
- Year 2 Vesting: 2 million shares vest at an FMV of $0.50 per share (2,000,000 shares x $0.50 = $1,000,000 FMV).
- Tax at 37% = $1,000,000 * 37% = $370,000
- Year 3 Vesting: 2 million shares vest at an FMV of $0.75 per share (2,000,000 shares x $0.75 = $1,500,000 FMV).
- Tax at 37% = $1,500,000 * 37% = $555,000
- Year 4 Vesting: 2 million shares vest at an FMV of $1 per share (2,000,000 shares x $1 = $2,000,000 FMV).
- Tax at 37% = $2,000,000 * 37% = $740,000
Total Tax Over Four Years Without 83(b): $1,850,000
This scenario demonstrates that without the 83(b) election, you are liable for taxes on the FMV at the time each portion vests, potentially leading to a much higher tax burden as the value of the shares increases. It's also important to note that the taxes estimated in these scenarios can be imposed on illiquid shares. This means that even though you are liable for substantial tax payments, the shares you hold may not be easily sellable or convertible to cash to cover these taxes. Without the ability to sell the shares, you will almost certainly face significant financial strain trying to meet your tax obligations.
Managing a Missed 83(b) Election:
Unfortunately, if you miss the 30-day window to file an 83(b) election, it cannot be filed late. However, there are a few methods practitioners normally turn to mitigate the damage:
1. Removing the Vesting Schedule. Accelerating your vesting makes the shares fully yours immediately. Generally, when you do not file an 83(b) election, property is subject to taxation as it vests, so when you accelerate vesting, you accelerate the taxation. If the FMV has increased by the time you remove the vesting schedule, you must pay taxes on the difference between this new FMV and the original purchase price. Estimating this potential tax liability before removing the vesting schedule is crucial to prevent significant financial strain.
However, boards and investors often struggle with accelerating the vesting of awards when an employee misses a section 83(b) election. Without vesting, equity incentives have no retentive effect, and the employee can quit without any risk of forfeiting the shares. Investors do not like fully vesting stock for something that was (in their view) the grantee's fault.
2. Making the Shares “Transferrable”. Another solution to a missed section 83(b) election is to make the property transferable by you to a third party. When property becomes “transferrable” within the meaning of Section 83, the fair market value of the property is included immediately in the service provider’s income. In effect, a result very similar to a timely section 83(b) election has been achieved. As with removing the vesting schedule, you are subject to immediate taxation on the difference between the FMV on the date the shares become transferable and the original purchase price.
This fix is also not without its issues. The amendment itself is highly technical. The shares must be fully vested if transferred to a third party, which investors do not like. There is very little guidance on the transferability fix from the IRS. For example, what are the parameters on who it can be transferable to and can normal company protective provisions like the right of first refusal continue to apply following a transfer?
In both cases, it’s crucial to obtain a 409A valuation to determine the stock’s fair market value. This will help you to understand the tax implications associated with accelerating the vesting following a missed section 83(b) elections. Depending on your company’s financial circumstances, your investors may be amenable to offering you a loan (which must be bona fide debt in order to be respected by the IRS) or paying you a discretionary bonus in order to help with any attendant tax consequences.
Canceling and Re-Granting Unlikely to Work:
Most tax advisors believe it is not effective to rescind the grant of property and make another grant of property that would be accompanied by a timely made section 83(b) election. This strategy likely does not work for tax purposes because the first grant would not be actually rescinded under the law. The IRS and courts would likely view this as an attempt, devoid of economic substance, to cure a late section 83(b) election.
Where does the Company come into play?
If you don’t make a section 83(b) election, the company has a withholding obligation on each applicable vesting date and can incur substantial penalties if such withholding is missed. It is also important to note that the company should be keeping execution copies of section 83(b) elections. A common misconception is that the company doesn't need to maintain records of Section 83(b) elections because it is a personal tax election for the grantee. While this is true to some extent, a requirement of making a Section 83(b) election is that a copy must be given to the entity for whom the services are performed. Therefore, maintaining these records is crucial for compliance and to avoid potential complications during due diligence.
We caution that the above is a summary and general in nature (it does not, for example, address partnership equity incentives or non-US tax implications) and does not address specific circumstances that may be important to you individually. It is not individualized tax or legal advice. Always work closely with a skilled startup lawyer to navigate these complex situations effectively and to ensure compliance with tax laws while minimizing liabilities.
Because this topic is so complex and important, I, as a startup lawyer, work with Brett Good, an experienced compensation and benefits counsel. We wrote this blog post together.
