Startup Law 101 Series – What is an 83 (b) election and how does it work in practice?
Introduction
The founders of a startup should have a working knowledge of the 83 (b) choice and this article seeks to give it to you.
This is a complex tax area and what is presented here is only intended to give a general picture of how 83 (b) works. Work with qualified tax professionals in this area to avoid landmines.
Here’s the working rule for founders: 83 (b) applies only when a founder has stocks and potentially to lose its economic value. When these conditions exist, it is normally vital that a founder files the 83 (b) election within 30 days of obtaining the stock award or they will face potentially negative tax consequences.
That is the general picture. Below is the tax theory and a more detailed explanation.
IRC section 83 applies to service providers who receive property in exchange for services
Section 83 (b) is part of section 83 of the Internal Revenue Code, which specifies how service providers who receive property in exchange for their services must pay taxes on the value of that property.
Section 83 (b) is closely related to section 83 (a) and actually works only to modify certain tax consequences that would otherwise apply to service providers under 83 (a).
Therefore, 83 (b) cannot really be understood without a basic understanding of 83 (a).
Section 83 (a) specifies how and when such service-related income is taxed.
Under 83 (a), if I obtain property in exchange for my services, I pay taxes on the excess of the fair market value of that property over what I paid for it.
Section 83 (a) then applies to service providers taking ownership as payment for services. Who is the main service provider in a startup? No, it is not the external consultant. It is the founder who works for sweat equity.
But let’s take the cases in sequence.
If I am a consultant and I get $ 5,000 in shares for my work done for a startup, I pay taxes on $ 5,000 in service income, that is, on the difference between the value of the shares ($ 5,000) and what I paid for it ($ -0-). That difference is taxable for me.
So far so good. That is intuitive.
But 83 (a) is more complex than that.
The founder who has to earn his shares over time is also treated by the IRS as an 83 (a) service provider. The founder can pay nominal cash for the shares and can own them, but as long as that ownership can be lost when the founder’s service relationship with the startup is terminated, the IRS considers the shares to be awarded in exchange for services.
Therefore, founding grants that must be earned (ie, are subject to risk of forfeiture) are included and taxed under 83 (a).
But 83 (a) does not impose an immediate tax on such gifts at the time they are made. It has a special rule that taxes such grants only when they are no longer subject to a “substantial risk of forfeiture.”
It is this special rule that creates traps for the unwary in the startup context.
The fiscal nightmare scenario for the founders
Suppose a founder is awarded 2 million shares at $ .001 per share and pays $ 2,000 for them. The shares are reasonably consolidated for 4 years at a rate of 1/48 per month. How does 83 (a) apply to this scenario? Under 83 (a), the tax authorities see the grant initially as 100% “subject to substantial risk of forfeiture.” Therefore, no tax arises from the beginning. But what happens each month when 1/48 of the shares are consolidated? Well, those stocks are no longer subject to any risk of confiscation as they are consolidated. Under 83 (a), then, each incremental consolidation event creates a potentially taxable event for the founder who owns those shares.
The risks to the founder may be slight at first when the company maintains the share price at the level of $ 0.001 per share. But what happens with the first financing? Of course, the price of the stock goes up, often dramatically. Let’s say that after a Series A round, the company sets its common stock price at $ 0.20 per share. Once that happens, under 83 (a), the founder who owns the original grant must pay taxes at each of their consolidation points.
How are you taxed? On the difference between the fair market value at that time of the shares that have just been sold (because the confiscation restrictions have expired for those shares), on the one hand, and the price you paid for those shares, on the other . In our example, this would mean that the founder earns taxable income on the difference between $ .20 per share and $ .001 per share for each of the shares that are awarded each month. If other funding occurs, and the common stock appreciates to $ 1.00 per share, then all founder shares that are awarded after that price change event are taxed on the difference between $ 1.00 per share. and $ 0.001 per share. . In other words, the founder is in the middle of a potential tax nightmare. With each of your multiple acquisition points remaining, you face a potentially large new tax impact. You would have 12 taxable events during the last year of your vesting cycle alone and (assuming common shares were valued at $ 1.00 per share during that period) you would get taxable income of just one shadow below $ 500,000, all for the privilege of having a piece of paper that you could not liquidate if you tried!
With this background, we can understand the importance and essence of an 83 (b) election.
Section 83 (b) comes to the rescue
While 83 (a) sets out the general rules for how service providers are taxed when they trade services for shares, 83 (b) gives them a way out of the nightmarish tax scenario just outlined.
Under 83 (b), a stock recipient who is subject to substantial risk of forfeiture may make a one-time election to have all of his interests taxed once and for all up front rather than incrementally taxed over time as restrictions on confiscation expire.
This means that if the aforementioned founder makes a timely 83 (b) election on his grant of 2 million shares, he chooses to pay taxes on the difference, as of the grant date, between the fair market value of the property received (that is, the shares, valued at $ .001 per share), on the one hand, and the amount you paid for them ($ .001 per share), on the other. In other words, the founder will pay taxes on the difference between the $ 2,000 the shares are worth and the $ 2,000 he paid for them. Since there is no difference between the two, the tax is $ -0-. This 83 (b) process replaces the 83 (a) treatment that would otherwise apply and eliminates the tax nightmare scenario discussed above.
After the 83 (b) election is made, the founder pays no tax on the grant up front and incurs no taxable income as the shares consolidate over time. Your holding period begins at the beginning for capital gains purposes and the only tax that would apply to such shares would be a capital gains tax at the time of sale.
So far the theory.
Tips on how 83 (b) is applied in practice
What does this mean in practice for the founders?
1. Many founders routinely assume that they need to make 83 (b) submissions regarding their stock grants because “that’s how startups work.” In fact, 83 (b) filings are only required in cases where the founder’s grants consist of so-called “restricted shares,” which is a form of shares where the founder’s shares are subject to forfeiture upon termination of his or her relationship. service with the company. .
2. If unrestricted stock grants are made to the founders or others, the 83 (b) elections do not apply because the shares are not subject to substantial risk of forfeiture.
3. While not often used in startups, in conventional buy-sell arrangements, if a business can buy back even the shares acquired from an outgoing founder at fair market value upon termination of a service relationship, 83 ( b) does not apply. If the repurchase is made at fair market value, there is no substantial risk of loss of the economic value of the shares. Therefore, filing 83 (b) is not required.
4. When a startup grants stock options to its key people, vesting is almost invariably used. The options themselves are subject to a complex set of tax rules, but 83 (b) is unrelated to any of them, except in one special case. If options are granted to key individuals who are granted the right to exercise them in advance, and that right is in fact exercised, those recipients will obtain shares that are subject to forfeiture if they do not obtain them during a prescribed period of service. . Due to the risk of forfeiture, an 83 (b) election must be filed at the time those options are exercised or these recipients may end up paying incremental taxes at each concession point, as described in the example above with the founder. Other than this special case of early exercise options, 83 (b) does not apply to stock options.
5. Not all 83 (b) elections will end up benefiting the service provider. Sometimes an employee in a mature startup is awarded restricted shares at a highly discounted price and that employee, upon filing an 83 (b) election, chooses to pay immediate tax on the spread between the market value of the shares. and the discounted price paid. . During the bubble era, these grants were often made in anticipation that the recipient would benefit after a company went public. In such a case, the recipient may end up paying a substantial tax in connection with the 83 (b) election – a tax paid, in essence, for the privilege of having a piece of paper. If the business fails, election 83 (b) in that case may result in the payment of an excessively high tax for nothing (a tax payment that is also not deductible). An 83 (b) election must be made very carefully any time a significant tax is owed at the time it is made.
6. From a procedural standpoint, an 83 (b) election must be held within 30 days of the grant date. This is done by filing with the IRS. The choice must be signed by the recipient and any spouse. The taxpayer must also submit a copy of Election 83 (b) with their tax return for that year. These rules are strict and must be followed to the letter.
Bottom Line: Turn to Professionals to Help You Get It Right
That ends our walkthrough for the benefit of giving the founder a bird’s-eye view of Election 83 (b). Again, this is by no means complete and nothing is certain in this area unless it is done under the supervision of a good business attorney. Use this for your practical knowledge and then make sure you get it right by working with competent professionals to help you implement the key steps.