For many startup founders, equity is the beating heart of their company’s value — and their own financial future. Beyond initial grants to founders — and, later, investors — equity is also a primary tool to incentivize gifted talent to join companies, especially when such startup companies are not able to pay substantial salaries. However, few early-stage entrepreneurs and service providers realize that a simple IRS form, filed at the right time, can make the difference between a manageable tax bill and an unexpected, painful liability down the line. Enter the 83(b) election.
In this post, we’ll break down what the 83(b) election is, why it matters to equity recipients, and how a small administrative step can pay major dividends down the line.
What is an 83(b) Election?
An 83(b) election is a proactive filing made with the IRS that allows an individual who receives restricted stock — typically stock that vests over time — to elect to be taxed on the aggregate value of the entire stock grant at the time of grant, rather than paying tax piecemeal as each tranche of the stock vests over time.
Normally, under Section 83(a) of the Internal Revenue Code, you pay ordinary income taxes when your stock vests (i.e., when it is no longer subject to a substantial risk of forfeiture). If your company grows rapidly (as everyone hopes), the value of your stock could skyrocket by the time it vests, creating a massive tax bill based on the appreciated value.
By filing an 83(b) election within 30 days of receiving the stock, you choose to recognize the value of the stock now — when it’s hopefully very low — instead of later. You also start your capital gains and QSBS tax treatment clock immediately for all of the granted shares. That way, future gains are taxed at capital gains rates (typically much lower) when you eventually sell.
Why Is It Important for Startup Founders?
1. Minimize Ordinary Income Tax
Founders typically receive stock when the company is worth very little. By electing under 83(b), you lock in that low value as the amount you recognize as ordinary income. If you don’t file, you risk being taxed at much higher rates on a much higher valuation as your company grows.
2. Start the Capital Gains Clock Early
The 83(b) election also starts the clock for long-term capital gains treatment. If you hold your stock for at least one year after making the election (and five years after grant for Qualified Small Business Stock benefits under Section 1202), you may qualify for significant tax benefits on eventual sale.
3. Protect Against a Liquidity Crunch
Without an 83(b) election, you might owe taxes on vested stock even if you haven’t sold any shares yet — meaning you owe cash taxes without receiving cash proceeds. Filing helps avoid this mismatch.
Let’s Use An Example
Here’s a hypothetical: say Jay just joined an early-stage startup as a key hire and was granted 480,000 shares at a price per share of $0.0001, with a standard monthly vesting schedule of 4-years (we’ll ignore the typical 1-year cliff for this hypothetical). That means that Jay vests into 10,000 shares every month over the course of 48 months. Simply put, in the eyes of the IRS, Jay only truly come into ownership of the shares when he vests into them, and he is only taxed on shares at that time. Thus, the IRS views each monthly vesting event as its own taxable event.
When Jay first received the shares, the fair market value of the shares was $0.0001 per share, so that first month’s worth of 10,000 vested shares was only worth a combined sum of $1.00, which is what the IRS would collect taxes on based on Jay’s applicable income tax rate. Naturally, Jay isn’t worried about such a small tax bill — and that trivial tax amount will likely remain the reality for the next monthly tranche he vests into, and the next, and perhaps even for the next two years’ worth of vesting. This is a startup after all — it takes time for the company’s value to increase.
But what happens if, say, three years from the date of his grant, Jay’s company has a major breakthrough and its shares are now worth $1.00 per share? Suddenly, Jay is vesting into $10,000 worth of shares every month, and he is taxed on that amount!
If Jay had filed an 83(b) election when he first received his grant, he would have locked in his $0.0001 share price, and he would have been taxed on a grant total of $48 worth of shares. On top of that, his capital gains and QSBS tax benefits would have begun to accrue on all of his shares from the date of his grant, rather than beginning piecemeal with each individual tranche of vesting. We see this sort of thing happen to real founders and other grant recipients — don’t let it happen to you!
What Happens If You Don’t File?
Unfortunately, missing the 30-day window for filing the 83(b) election is irreversible — there is no late filing option. If a grant recipient missed their deadline and the oversight is caught early on, sometimes they can work with their company to forfeit back the shares and then have the company re-grant them, thereby resetting the 83(b) election clock. Keep in mind though that, upon such re-grant, the shares will need to be offered at whatever the current fair market value is. You cannot go back in time and re-grant shares at a previously applicable price per share.
As such, this forfeiture and re-grant solution only works in certain situations, and entails hassle and legal expense for the company and the grant recipient. Recipients can prevent this from the outset by ensuring they file their simple 83(b) election on a timely basis.
How to File an 83(b) Election
- Complete the 83(b) election form (IRS does not provide an official form — your legal counsel can help).
- Send the completed form to the IRS within 30 days of the stock grant (not the vesting date). **Again, this is a firm and inflexible deadline!!
- Send a copy to your employer (i.e., your startup) for their records.
- Retain proof of mailing (send via certified mail with return receipt or similar).
- Keep a copy for your own tax records.
Final Thoughts
The 83(b) election is a small but crucial step for startup founders and other grant recipients. It helps align your tax treatment with your startup’s growth trajectory and gives you the best chance to maximize your ultimate returns. Miss it, and you might be stuck with taxes that could have been avoided.
At Bowery Legal, we specialize in guiding startup founders through all processes related to granting equity, including 83(b) elections. If you need assistance, or have any questions on the topic, don’t hesitate to reach out to our team for help.