Typically, any blog post or article about a section of the tax code promises to be a snoozer, but knowing about Section 83(b) is crucial to any startup founders and employees. It’s pretty easy to do it right, but if you are sloppy or uninformed, and you mess it up, and you are in a world of pain. This could be the most important blog post any startup founder or employee reads.
Why is Section 83(b) so important? Typically under Section 83 of the tax code, a founder or employee does not recognize income on stock until the stock vests. When I refer to income, I mean the difference between the fair market value of the stock and the price paid for the stock. Section 83(b), however, allows the founder or employee to make a voluntary election to recognize income upon purchase of the stock, rather than waiting until the stock vests. If the founder/employee does not make the 83(b) election, she may have a great deal of income by the time the stock vests, particularly if the stock value increases substantially over time. OK, I know your eyes are glazing over, but indulge me a bit longer.
Let’s look at two different scenarios — failing to make the 83(b) election, and making the 83(b) election. Suppose we have two co-founders, Reggie and Daniella. Each gets 1 million shares of stock when they form their corporation, at a price of $0.001/share. The stock is subject to four year vesting with a one year cliff (see my other blog post on the importance of vesting). Reggie does not make an 83(b) election. By the end of the first year, 25% of Reggie’s stock is vested, and because of the efforts of the founders and the interest shown in the company by investors and the public, the stock is now worth $1/share. Reggie recognizes income on the vested stock equal to the difference between $1/share and $0.001/share, or $0.999/share. Multiply that by the number of his vested shares, and you’ll see that Reggie has recognized income of $249,750 on his vested shares. As time goes on and more of Reggie’s stock vests, he will continue to recognize income equal to the difference between the FMV of that vesting stock and the original price of $0.001/share. In addition, the company has to pay the employer share of FICA tax on the income, and withhold federal, state and local income taxes. Both Reggie and the company are taking a big tax hit because he failed to make that 83(b) election.
Now let’s look at Daniella. She got the same amount of stock, at the same price, and is subject to the same vesting schedule, but she made the 83(b) election. Instead of recognizing income of $249,750 at the end of Year 1 when 25% of her stock vests, she chose to recognize income at the beginning of Year 1, when she first received the stock and when its fair market value was pretty much equal to the price of $0.001. So basically, Daniella recognizes no income, because at the outset the stock had no real value.
Hopefully these two examples will make clear why the 83(b) election is a crucial issue for founders and employees. To make a timely 83(b) election, the purchaser must file the election with the IRS prior to the date of purchase, or within 30 days after purchasing the stock. No exceptions. In counting those 30 days, the IRS includes Saturdays, Sundays, and holidays. Best practice is to sign the 83(b) election form immediately upon purchasing the stock, and mail it by certified mail, return receipt requested, to the IRS that same day. Give a copy of the signed 83(b) election to the company for its records, and attach a copy to the purchaser’s federal tax return for the year in which the stock was purchased.