If you’re vesting equity shares, it’s important to understand 83(b) elections. Under Section 83 of the Internal Revenue Code, any income you receive from owning equity in a company is not taxable until that stock vests. For most startups, issuing founders’ shares when you first form the company makes sense. At that point, your IP is your biggest asset and the market value of equity shares is almost zero.
For most startups, the value of the equity shares increases—sometimes significantly—over time. That means you would have to pay tax on shares that are valued much higher than when you formed the company.
An 83(b) election applies to equity that is subject to vesting. Filing an 83(b) election instructs the IRS to tax you when equity is granted, instead of waiting until the shares vest. This can save you significant money.
For most founders, the fair market of equity shares when founding the company is zero, so the taxable income is zero. If you file an 83(b), you won’t have to worry about paying higher taxes after your equity vests. But you must file an 83(b) election within 30 days from the date that the shares are issued.
Without an 83(b) election, a founder would have taxable income at each vesting date. You would pay taxes on the difference between the fair market value of shares that vested and the price paid for such shares. That would require you to track, appropriately withhold, and pay employment taxes on the value of the equity shares.
It makes sense to consult an individual tax advisor or lawyer who specialized in startups before filing an 83(b) election. Dinesh Moorjani, serial entrepreneur, investor, and advisor notes, “Having a great startup law firm that has the pattern recognition and experience, having worked across a number of issues that arise during a complex and tumultuous startup journey essentially reduces the statistical risk of that startup being at risk of failure.” He advises working with a professional to get the setup structure right for 83(b) elections “so that you have proper capital gains treatment for appreciation of the stock value for the founders.”
Assume a founder receives 100,000 shares at $0.00001 per share at the time of grant. Vesting has a 3-year cliff after which the shares are worth $1 each. The company is eventually sold at $10 per share. The ordinary income tax rate is 40% and long-term capital gains tax is 20%.
Scenario 1: You File a Section 83(b) Election
You file an 83(b) when your shares are worth $1. Your tax payment for the stocks is $0.4 ($1*0.4). At the time of fully vesting, you pay no additional taxes. At the time of sale, you then have a taxable gain of $9.99 per share (you already paid $0.00001 at the start), and taxes are $199,999.8 ($999,999*0.2).
Economic gain after tax: $800,000 ($1,000,000 minus $0.4 minus $199,999.8)
Scenario 2: You Do Not File a Section 83(b) Election
Since you didn’t file an 83(b) election, you pay no tax at grant. When your equity is fully vesting, your shares are worth $100,000. You must pay taxes of $40,000 ($100,000*0.4). On the later sale date, you have a taxable gain of $9 per share. Your taxes then amount to $180,000 ($900,000*0.2).
Economic gain after tax: $780,000 ($1,000,000 minus $40,000 minus $180,000)
It makes sense to file a Section 83(b) Election if a founder receives stock worth a nominal amount. You must file an 83(b) within 30 days after the grant date.
83(b) Template and Instructions. It’s important to note that the IRS doesn’t provide a form for 83(b) elections. However, Fidelity Investments has provided a template for section 83(b) elections. It also includes instructions for completing and filing the form.
In What Is a Section 83(b) Election and Why Should You File One? Matthew Bartus, Partner at Cooley GO, delves deeper into the importance of 83(b) elections for founders. Bartus specializes in solving legal and business problems for high-growth companies, from founders with an idea (who are typically pre-incorporation) to established later-stage businesses.