As exciting as receiving equity in a growing startup can be, without advanced planning, that equity can carry with it some severe tax consequences. An 83(b) election is a tool that new stockholders who are subject to vesting can use to mitigate the tax burden that otherwise comes with the vesting of their shares.
Granting equity has massive advantages for startups, from rewarding service providers and attracting talent, to aligning everyone toward growing the business. Often, these equity grants come in the form of options, which vest and become exercisable over time. However, when the recipient comes in early enough that the fair market value of the stock is low, wants to flex the rights associated with that equity immediately, or wants to work with a different tax structure, the company may issue the recipient “restricted stock.”
Let’s talk taxes
Stock is an asset, which carries with it economic value. However, the lapsing right of repurchase attached to restricted stock makes the actual value of that stock, and the scheduled recognition of that value, more complicated for tax purposes.
The IRS considers a right of repurchase to constitute a “substantial risk of forfeiture,” which means, generally, that the taxpayer receiving the stock faces a real possibility of losing that stock.
When that substantial risk of forfeiture goes away and the stock becomes unrestricted, the IRS remeasures its fair market value and taxes the taxpayer based on the amount the fair market value has increased since the stock was purchased. In effect, if the value of the taxpayer’s stock is increasing as restrictions are lapsing, the coming tax bill is increasing, too. That means every time stock vests, there is more tax to pay (assuming increasing value).
This is especially problematic for startups, who often issue stock at very low valuations initially and (ideally) quickly grow in value. Thankfully, there is a solution to mitigate these tax consequences: the 83(b) election.
The 83(b) election is a one-time election that allows the recipient to be taxed on the fair market value of their restricted stock at the time of the grant, rather than when the restrictions lapse.
For a growing company with a valuation that increases over time, the shift in taxes can add up to tremendous savings.
Here’s an example:
Fact Pattern: Two employees of a startup are granted 1,000 shares of restricted stock. Each employee purchases the stock at $1.00 per share, equal to its Fair Market Value (FMV) at the time. The shares vest after one year. At the end of that year, the Fair Market Value of the stock is $100 per share. One employee, Employee A, decides not to file an 83(b) election. Employee B does file an 83(b).
Employee A: No 83(b): 1,000 shares x $99 (increased FMV) per share = $99,000 of taxable ordinary income.
Employee B: With 83(b): Fair Market Value at Grant = Fair Market Value at Election. Since the stock was bought at Fair Market Value, no tax.
Difference: $99,000 of taxable income saved with an 83(b) election.
That example may be a bit pronounced, but it demonstrates the point: filing the 83(b) election and buying in early to a growing startup can save the recipient a lot of money.
To be clear: The example above assumes that restricted stock is sold to the taxpayer at its Fair Market Value at the time of issuance. Since there’s no income or gain in that transaction, that’s not a tax event. However, if that restricted stock is instead granted to the taxpayer at a price under the Fair Market Value, for free or for “sweat equity”, that will also be a tax event.
It’s possible that an 83(b) election can result in a stockholder paying higher taxes if the valuation drops, but most folks are optimistic the value will increase, else they wouldn’t want the stock in the first place.
What if the recipient sells the stock?
If a potential seller has filed an 83(b) election on their restricted stock, the calculation of their taxes owed will change a little. Stock is a “capital” asset, which means two things:
Sellers are taxed on their “gain” on the sale, not the full sale prices, and they are taxed as capital gains rates, not ordinary income rates.
“Gain” is calculated as the sale price less the seller’s “basis”, which equals the amount of income the Seller has previously recognized on the stock. In other words, the more taxable income previously recognized (and higher tax paid), the less gain the Seller will recognize on the sale of their stock.
Let’s walk through an example:
Fact Pattern: Same as above, but the employee sells all of their stock for $200,000.
No 83(b): $200,000 Sale Price – $100,000 ($1K cost basis + $99K income through FMV growth for which tax has already been paid) = $100,000 of Capital Gain.
With 83(b): $200,000 Sale Price – $1,000 (cost basis) = $199,000 of Capital Gain.
Difference: $99,000 additional capital gain recognized with an early 83(b) election.
It looks, at first blush, like the tax impact has evened out. Over the two taxable events, both Employee A and Employee B have recognized $199,000 of income. However, nearly all of the Employee B’s income is going to be taxed at the lower capital gains rates, compared to only half of the Employee A’s income.
There’s another small thing to remember here. Capital gains are actually divided into “short-term” and “long-term” rates, with short-term rates historically higher, equal to ordinary income tax rates. Whether a gain is short-term or long-term depends on how long the asset has been held; in order for it to be considered a long-term capital gain, the asset needs to be “held” by the seller for more than a year.
Why does that matter here? Because when the 83(b) election is filed, that “one year holding” clock starts as soon as the election is effective. Otherwise, the grantee does not “hold” the stock until the right of repurchase lapses. In the last example, if Employee A sells their stock as soon as it vests; or they have not held it for a year the money from the sale would not receive long-term capital gains treatment. Employee A would again be paying ordinary income tax rates on their income.
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Filing an 83(b) election is very often the right move for anyone receiving restricted stock, especially those investing in the success of a growing startup. However, tax planning often changes in some niche scenarios, so tax advisors should always be consulted before filing such an election.