83(b) election typically applies to founders or early-stage employees who received restricted stock units. This election is designed to help founders and employees to shield themselves from unnecessary tax liabilities down the road. We will discuss the concept briefly in our post and will share some good templates and know-how for you to follow. At any time, you still should follow the advice of your legal counsel or attorney to ensure the proper filing of the paperwork.
Who Should Be Aware Of 83(b) Election
Typically, startup founders or early-stage employees issue themselves a large portion of a company’s shares when the company really didn’t have much value in the market. For example, the Company was just registered with the State of DE and authorized 10M shares of common stocks. The CEO decided to issue 75% of the 10M or 7.5M shares to the 2 co-founders in different proportions. The stock has some restrictive language such as a 1-year cliff, and a total of 4-year vesting period. Within 30 days of receiving the stock issuance (typically through the signing of the stock agreement), the co-founders should report this reception to IRS through the filing of the 83(b) election. The Company’s stock par value (remember you had indicated to the State of DE that each of the 10M shares is worth about 0.0001 cents) is so low that it will have minimal to no tax impact on the co-founders or employees by claiming it to the IRS as income.
Here are a few key characteristics for this election to make sense:
1. The stocks have restrictive features – such as the 1-year cliff and 4-year vesting as an example
2. The par value stock price is very low currently – 0.0001 cent a share, so by claiming it, it’s not considered as having a huge tax impact on your current 1040 filing. Most founders elect to pay for it so it doesn’t have to be included as income.
3. There isn’t much true progress as to the Company business plan currently that would invalidate the extremely low par value stock price
4. The stock is issued – as opposed to the stock class is merely authorized to be issued in the future
Example of consequences for not filing 83(b)
Assuming one of the co-founders received 2M shares out of the 7.5M total issued and had met the 1-year cliff requirement on 1/1/2020. On this date, the Company made meaningful progress in terms of product development, customer acquisition, and/or fundraising. And the 409A value of the stock had become 1 cent per share (a 10,000-time increase in stock value). Here is the tax consequence when the year 2020 ends:
1 cent X 500,000 shares (25% of the 2M) = 500,000. This is the amount of deemed income that needs to be included in the year-end tax filing of the individual. Assuming a tax rate of 20%, this represents roughly 100,000 of cash outflow. In the case of the other co-founder who filed the 83(b), there is no tax event at the same time when the vesting has been met.
It is important to point out that if the Company went to IPO or had a successful exit, the eventual tax consequences of both co-founders may not differ as much. However, we are trying to avoid paying cash taxes for stocks that are not tradable at the moment while there are still uncertainties associated with the stock going down in value.
Templates to Use for Properly Filing of 83(b) Elections
Step 1 – Fill out the IRS election template
If this becomes a DIY matter, follow the instructions outlined here for the election form that took straight out of the IRS template (Click to Download)
Line 1 – Type in your individual legal name, social security number or ITIN, address, and the calendar year you received the stocks
Line 2 – Type in the total shares of stocks that are granted to you and the name of the Company
Line 3 – The date of issuance
Line 4 – Indicate any vesting schedules, or this is typically how corporate counsel writes it here ” The Company may repurchase all or a portion of the shares at the Taxpayer’s original purchase price under certain conditions at the time of Taxpayer’s termination of employment or services
Line 5 – The par value times the number of shares issued
Line 6 – Most founders choose to pay for it so line 7 is zero income. But if you want to include this in your income, then leave it zero here
Line 7 – If you paid outright, then zero to include here as income, but if you didn’t pay for it, then include the fair value at the grant as your income.
Make sure you Sign and Date the Form.
Step 2 – Transmittal Letter to IRS and Mailing
Again, here is a template you can use (Click to Download), and some instructions below to follow:
Make sure you print two signed copies of your election and include in your mailing package stamped and self-address envelops to allow the IRS to rubber stamp and mail back the extra copy which confirms the receipts of the election. Do remember to use certified mail and return receipts so you have some evidence to show you did it on time if the IRS dropped their ball.
What if I missed the 83(b) election
In case you are sure that the election was never made (i,e. the 30-day has passed after issuance), below are the most common 2 ways to help mitigate the tax consequences mentioned above. Please note, they both have a business and some tax liabilities immediately for selecting either approach:
Alternative 1 – Regrant the stock
Regranting the stock will necessitate using the current valuation of the Company, it will also start a new 30-day window for the recipient to file the Sec. 83(b) election. Assuming your current valuation of the Company is more than 0.0001 per share but less than 1 dollar, this may indicate a few thousand dollars in taxes today as compared to hundreds of thousands in the future.
The decision behind this one is that it makes sense only if the current FMV/409A value is low. This approach is also the easiest and most doable approach of all. The ability to lower your FMV through the 409A study is much more difficult if your business has made significant progress such as increased sales, and profit, or having raised outside capital.
Alternative 2 – Amend the initial grant and have it vest immediately
This fix has similar tax consequences in the sense that the current FMV will be used to value the total amount of stock issued. Because we are treating all stock issued as having vested, the tax liabilities will be what the FMV of the stock times your personal income tax rate as of today.
The decisions behind this one include both cash tax and business considerations. Business considerations include that this approach removes founders or employees’ vesting restrictions so that they are no longer subject to any vesting schedules; something typically requires board approval for sure. That’s why it is one of the less common ones to actually implement.