As a business lawyer based in Austin, with clients throughout Texas, Delaware and other states (even a couple in other countries), a large part of my legal work involves technology startups – companies where founders put in very little money, raise a few rounds of angel investment and venture capital over a few years, and aim to scale their startup from the garage to an IPO or lucrative exit through a merger or acquisition (M&A).
Over the years, I’ve found that startup clients often struggle to understand 83(b) elections. Worse, I’ve run into startup founders who are well past the launch phase and who weren’t told about 83(b) elections at all when they were launching their startup.
While I am not a tax lawyer or CPA, I’ve picked up some knowledge about tax law throughout the years and 83(b) elections are a fairly easy concept to understand. If you’re launching a startup and intend to pursue angel investment and venture capital, take the time to understand 83(b) elections – they can save you a lot of money! And, while filing an 83(b) election is generally the right move for an early-stage startup founder, it may not always be the right move – so, understand what you’re doing.
I can’t promise this will be fun reading, although I will make it quick and relatively painless.
The General Context Where 83(b) Elections are Very Useful
If you are a startup founder, including technology startups (SaaS, hardware, AI – any scalable business that’s a candidate for institutional early-stage investment) that intends to raise multiple rounds of venture capital, you may have been told you ought to vest your stock. Or, perhaps a venture capitalist or angel investor told you that you must vest your stock, maybe they’ve offered you capital but conditioned the investment on implementing vesting for your founder’s shares.
When you vest shares of stock (you can also vest other equity, such as limited liability company membership interests), even though you are issued a certain number of shares of stock, they aren’t entirely yours. The shares have restrictions and are subject to forfeiture if you don’t stick around long enough (time-based vesting) or if you don’t reach certain performance goals or metrics (performance-based vesting). Most vesting you’ll see in technology startups is reverse-vesting where the corporation (most startups choose to form as Delaware c-corporations) has a right to buy back the unvested shares if the founder leaves early (generally, founder startup shares vest over four years).
The combination of vesting and the likelihood of doing financing rounds at higher and higher valuations is the one-two combination where 83(b) elections are very important and can make a huge difference in what you, as a startup founder, keep in your pocket ultimately.
The Basics of 83(b) Tax Elections
83(b) elections take their name from Section 83(b) of the Internal Revenue Code (creatively named!).
To understand 83(b) elections, you need to understand two basic tax principles –
- If you receive property and the property is worth more than what you pay for it (if it’s given as compensation, you may pay nothing!), you will be taxed at ordinary income tax rates on the difference between what you pay and what the property is worth.
- If you are given stock that is subject to vesting, the IRS doesn’t treat you as actually receiving the stock until it vests (i.e., until it’s truly yours and no longer subject to forfeiture).
An 83(b) Election Startup Example
Let’s look at a hypothetical startup founder situation. Let’s say our startup founder receives 2,000,000 shares subject to vesting over four years with a one-year cliff. This is a typical Silicon Valley-style startup vesting schedule. The cliff means that one quarter of the total shares will vest at the same time at the end of the first year, whereas the remaining three quarters of the shares will typically vest in equal amounts over each of the following 36 months. Until the one year anniversary of the date the shares were granted (technically, they are usually sold to the founder for a small amount) to the founder, no shares vest. If the stockholder were to leave – stop working for the startup – before the one year anniversary, the founder won’t walk away with any shares. The point of vesting is to ensure that the startup’s equity, which is limited and precious, is in the hands of people who are working to make the startup successful. That’s critical. You don’t want to give someone shares of stock without vesting, expecting that person to be integral to the growth of the company, and have them leave early on with a lot of shares.
On Day 1 (at the time the startup is being incorporated), the startup is likely worth very little. If it was just formed, it may have a value of zero. If the founders put a small amount of capital into the startup, it is likely valued at the amount of capital they put in (it’s always recommended to put some capital into a company upon formation since not doing so can be a legal risk, especially with corporations where courts expect the corporation to be “adequately capitalized”). There may be some intellectual property, although that’s usually tough to value in any meaningful way and sometimes it is contributed after the founder shares are purchased anyway. Therefore, the startup founder in our example is not receiving value in excess of what she (doing my part to acknowledge that women founders can play this game, too!) paid for the shares. Her 2,000,000 shares are likely worth something between zero and a nominal amount of “paid-in capital.” Either way, the value of the shares equals what our founder paid. And, that’s the way things often work in a new startup.
If our startup founder received all 2,000,000 shares today, without any vesting restrictions, there would be no taxable event. Again, this is because the shares are worth what she paid. In this case, her basis (this is a fancy tax term for the amount of her investment and is important later on when the stock is (hopefully) sold for a huge gain, at which time our startup founder will pay tax on the difference between the sales price and her basis, likely at capital gain rates) in the stock would be the amount she paid for the stock — zero or a small amount of paid-in capital.
Remember, though, we are assuming the stock received by our startup founder is subject to vesting. Because of the vesting restrictions, the startup founder is treated by the IRS as not having received anything on Day 1 because no shares of the stock she received are vested yet. Instead, the IRS treats her as having received something for the first time on Day 365 when the first vesting event occurs. With a one-year cliff, if ¼ of the total number of shares vests, the IRS would say that our startup founder received 500,000 shares of stock on Day 365. And, that could be an issue for our founder …
How Things Look if a Startup Founder Doesn’t File an 83(b) Election
On Day 365, the IRS will treat our startup founder as having received 500,000 shares – the 500,000 shares that just vested. Meanwhile, it is possible that between Day 1 and Day 365, the value of the company went up, hopefully WAY UP! If the startup raised financing in a priced financing (where equity was sold at a specific valuation) round or there was some other event that establishes a valuation for the company (who knows, maybe the company even has some early revenue!), there is a valuation and it is likely much higher than the valuation of the startup on Day 1.
Those 500,000 shares our founder is deemed to receive on Day 365 could be worth quite a bit more than she paid for them. Remember, our startup founder paid nothing or a very small amount of paid-in capital for those 500,000 shares. Therefore, when the shares vest, assuming no 83(b) election was filed, our founder will have a taxable event and she will owe taxes. She will be required to pay ordinary income tax on the difference between what she paid for the 500,000 shares on Day 1 and what they are worth when she is deemed to have received them on Day 365.
In this case, her basis in the shares will be the value of the stock on Day 365. When she sells that stock later, she will pay capital gains (assuming she holds the shares for at least one year) on the difference between her basis and the sales price. But, that’s a small consolation when compared to the fact that she needs to pay taxes – actually fork over cash – but her shares are still illiquid (their value is entirely on paper at this point).
The Same Fact Pattern if the Startup Founder Files an 83(b) Election
By filing an 83(b) election with the IRS, our founder can choose to recognize taxable income on Day 1 even though her shares of stock are subject to vesting. If our startup founder files an 83(b) election within 30 days of first receiving the stock grant of 2,000,000 shares, the IRS will require she pay tax on all the taxable income she receives on Day 1, regardless of the vesting restrictions. Since, as we discussed, there is often no difference between what the startup founder paid for the stock on Day 1 and what it is worth on that day, being taxed on the taxable income doesn’t matter – there is no taxable income, so there is no tax due (again, this is a common situation – don’t be silly and rely on an internet article as your sole source of advice when the stakes are high – talk to a CPA!).
Her basis in the stock is then nothing or the nominal value she paid. When she sells the stock later, she will pay capital gains (assuming she holds it for at least one year) on the difference between the basis and the sales price. So, ultimately, the IRS, being the IRS, will collect tax on the income. From a timing perspective, though, our founder is way better off by filing an 83(b) election and, there is a benefit in that she is more likely to pay capital gains on the taxable income vs. ordinary income (which is likely at a higher rate than the capital gains).
Adding in Some More Numbers to Our Startup 83(b) Example
Let’s put some more numbers to our example. I am making the following assumptions (which may not be realistic in real life) to simplify the example:
- There are 5,000,000 shares of stock outstanding on Day 1 and at the end of Year 5. It’s common with technology startups, which are usually Delaware corporations, to authorize a total of 10,000,000 shares of common stock in the Certificate of Incorporation/Formation, but not issue all those shares right away – some are held back for investors and a future stock option pool for employees. So, more shares would likely be issued over time, but again, let’s keep this easy to follow.
- I assume the company is worth nothing on Day 1, even though it is probably worth a couple thousand dollars based on some small amount of paid-in capital and could be worth more if intellectual property or more cash is contributed right away.
- I assume the value of the company increases year over year and that the company is sold for $100,000,000 at the end of five years.
- I assume one quarter of the shares vest on each of the first four anniversary dates of the initial issuance of the stock. As I explained earlier, a common vesting schedule is four years with a one-year cliff, which means no shares vest for the first year and shares vest monthly after the first year. Again, though, keeping it simple.
- I assume our startup founder is subject to a constant ordinary income tax rate of 40% and capital gains tax rate of 20%.
Comparing the Outcomes in Our Startup Example
The total tax paid by the startup founder in our example if she timely files an 83(b) election is $8,000,000. If she fails to timely file an 83(b) election, she will pay a total tax of $9,700,000. $1.7MM – that’s real money at stake.
And, there are other issues than merely the total amount of tax paid. It’s less desirable to pay the taxes along the way, a little each year, than once at the end of Year 5 because a dollar today is worth more than a dollar tomorrow.
Additionally, our startup founder has the issue of figuring out how to get the cash to pay the taxes along the way. She’d have to sell shares somehow and that isn’t always easy with private companies. And, while it’s not included in our example, if she sold shares along the way, she wouldn’t actually realize $40,000,000 at the time of the sale because she wouldn’t have 2,000,000 shares still – this would reduce her total walk-away amount.
While not reflected in this example, another concern that’s alleviated by filing the 83(b) election is that our startup founder’s holding period for purposes of determining capital gains treatment begins on Day 1. If, on the other hand, she did not file an 83(b) election, her holding period for each share will begin when the share vests. So, if she had vested the final one quarter of her shares at the end of Year 4 and then sold all her shares six months later, she wouldn’t have long term capital gains treatment on the last quarter of the shares because she would not have held them for at least one year.
If the company goes from a valuation of $50MM at the end of Year 4 to nothing — in other words, if the company implodes instead of being sold, the situation is even worse – much, much worse, in fact. In that case, our startup founder will have paid $3.4MM in taxes along the way, but she will have realized no actual cash from holding the shares because she will have never sold them (or, she may have sold a few shares, but only to pay taxes – she still wouldn’t have any true gain).
When You Ought to Think Twice Before Filing an 83(b) Election
In the typical founder startup context (with respect to a grant or sale of founder shares), the 83(b) election is a no brainer. Where it becomes a tougher call is if you are granted stock, subject to vesting, in a company that’s been operating for a while and by filing the 83(b) election you accelerate the payment of actual taxable income, i.e., there is a difference between what you pay for the stock and what the stock is valued at right then. This is often the case with employees who are granted restricted shares (subject to vesting) when a company is past the initial startup stage. They often pay nothing for those shares because they are given them as compensation.
During Dotcom 1.0 in the early 2000s, I knew plenty of people that did this — electing to take the tax hit upfront, assuming the stock would just keep going up and up. Some of their companies were out of business and were worth zero by the time the shares vested. In those instances, the employees paid taxes and never received cash for the shares.
File on Time or Lose Your Right to File the 83(b)
Assuming your situation is the same as what I am calling the “typical” startup scenario (when making this determination, talk to your lawyer or accountant), file your 83(b) election! You have 30 days from the date you are granted shares of stock to file the election. There is no grace period. File your 83(b) election within 30 days or lose it forever!
Send a copy of your 83(b) election to the IRS by certified mail with return receipt requested (as of today, you send it to the address where you file your tax returns, although verify this at www.irs.gov or by calling the IRS at (800) 829-1040). You also need to include a copy of the 83(b) election with your next tax return filing.
You will ultimately end up paying taxes on the increase in value (it’s the IRS – they get paid in the end), but it is much better to pay it later and based on capital gains rates rather than along the way and based on ordinary income rates.
So, there you go – not fun, but painless, right? And, never say the IRS didn’t do something for us or that there is no such thing as a free lunch. In this one context, they did and there is.
If you have questions about 83(b) elections or other questions about startups or corporate and business law generally, give me a call at 512.888.9860. I am an Austin-based lawyer with an office in Houston, although I have technology company clients all over the country.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.