83(b) Elections for Startups (avoiding ordinary income tax)
Most startups don’t have the need to wrestle with the problem of having too much cash. Usually, quite the opposite is true – they have too little. To compensate for this lack of cash, startups may try to pay employees and contractors (“service providers”) using equity incentives instead of cash.
For example, let’s say a mobile app company (the “Company”) needs an iOS developer and agrees to give that developer, in lieu of cash, 80,000 shares of stock subject to vesting of 40,000 shares at the end of each 12 month period from the grant date. If the shares have a fair market value of $0.08 per share when the grant is made, one might think that the income from this transaction under IRC Section 61 (the amount on which you would pay taxes) would be $6,400 (80,000 x .08). In that case, if the employee or contractor had no other income, the employee would be at an effective federal income tax rate of 10% and owe approximately $640 in income tax for the grant.
But Section 83(a) of the Internal Revenue Code requires the stock grant to be taxed as income as of the respective vesting dates, instead of when the grant was made. So, let’s say that at the end of the first 12 month period (from the grant date), the shares are worth $2.08 per share, and at the end of the second 12 month period, the shares are worth $4.88 per share. At the end of the first 12 month period, the first-vested shares would be worth $86,400. At the end of the second 12 month period, the second vested shares would be worth $195,200. This would mean that if our iOS developer had an effective federal income tax rate of 30% (assuming our iOS developer is single – no disrespect intended against iOS developers), the developer would pay approximately $84,480 in federal income tax for those two years of service. That stings, and is the reason why Section 83(b) is an important consideration.
If the employee or contractor makes an 83(b) election at the outset, the income required to be recognized on the shares will be determined as of the grant date, instead of the vesting date, for a total initial savings of approximately $83,840 on our facts. Even if we assumed that the effective federal income tax rate was 30% for all scenarios, if the shares were received solely for services (and did not include any amount of payment for the shares) the immediate savings would still be over $80,000. That doesn’t suck.
The catch is that if the 83(b) election is made, our iOS developer has a lower basis in the stock (the value as of the grant date), and therefore, when he/she goes to sell those shares, a greater capital gain (assuming the stock continues to increase in value after vesting and by the time of sale) tax liability will be incurred. For example, let’s say our iOS developer holds the shares for an additional 14 months after the last vesting date and decides to take another opportunity (another company successfully swooned him/her) and also decides to sell his/her shares in the Company. At that point, the sale would be considered a long term capital gain (e.g. with a top federal rate, as of the date I authored this post, of 20% plus a 3.8% net investment income tax).
Depending on your effective federal income tax rate, you might not immediately see what the big deal is. But for most employees, the big deal is that if they don’t make the 83(b) election, they might not have the money to cover the tax liability for that equity, because they were working for equity instead of cash. In contrast, if the employee only incurs tax liability in the form of capital gains, that liability can be covered by sale proceeds.
Two other important items to keep in mind when considering an 83(b) election: (i) irreversibility, and (ii) timing.
Irreversibility: In general, after the 83(b) election is made, it is irreversible. This can be problematic for several reasons. For example, if the election was made and the value of the equity tanks, the employee’s only solace comes in the form of a capital loss (if that loss can even be used by the employee/taxpayer). And if the stock never vests, there is still no way to get a refund of the tax paid on the value of that equity as of the grant date. Generally speaking, if the equity is worth little or nothing, the risk of making the 83(b) election is small. In fact, if the equity has zero value, making the election may not trigger any tax at the time of transfer. And although the 83(b) election can decrease tax liability for service providers and founders, employees should spend more time considering the risks if the value of the equity as of the grant date is more significant.
Timing: In general, the 83(b) election must be made within 30 days after the grant date. Because of the lack of flexibility on this issue, if the employee misses the deadline, that employee may be stuck with a huge tax burden that leaves the employee bitter and feeling like they gave their heart and soul for little to no compensation.
Recap of the basics: In general, the 83(b) election is made according to Treasury Regulation Section 1.83-2 and the IRS has provided sample language in Revenue Procedure 2012-29. There is a strict 30 day deadline for making the election. If you think the value of the equity you are receiving will increase, an 83(b) election can potentially save you some cash (and reduce stress).