Understanding the 83(b) Election
If the shares of stock you acquire in your startup are subject to vesting (or a “substantial risk of forfeiture” as the IRS calls it), then you typically want to make what is called an 83(b) election. The 83(b) election is a simple letter you send to the IRS to inform them that you want to be taxed on your shares on the date they were granted, rather than the date they vest (or, in IRS speak, the “date the substantial risk of forfeiture has lapsed”). The difference sounds minor, but it can mean huge dollars. Here’s an example:
“Founder is issued 4,000,000 shares of common stock at incorporation at a price of $0.0001 per share, which the company’s board of directors determines is the fair market value on the date of incorporation. Founder pays $400 for the shares, which are subject to monthly vesting over 4 years, with a 1-year cliff (meaning none of the shares vest during the first year, and then 25% of the shares vest on the 1-year anniversary of the date of issuance). After year one, the Company has enjoyed great early success and raised some money at a good valuation, and the shares are now valued at $200,000.”
If Founder had made the 83(b) election, Founder would be taxed on the difference between the amount Founder paid for the shares ($400) and the fair market value on the date of issuance ($400), resulting in no tax bill at incorporation. Founder will not have to worry about another tax bill until Founder sells the shares. If the shares are sold more than one year after they were acquired, the sale will be subject to long-term capital gains treatment (a beneficial result to Founder).
If Founder didn’t make the 83(b) election, Founder will be taxed on each date that shares are vested, and the tax will be at the ordinary income rate (a higher rate than long-term capital gains for most individuals). This means on the one-year anniversary of incorporation, Founder will be taxed on the difference between the price paid for the shares at incorporation and the $50,000 value of the vested shares at the one-year anniversary ($200,000 x 25% = $50,000), and then as the remaining shares vest each month thereafter, there will be another taxable event between the amount paid for the shares and the value of the shares on each date they vest, resulting in not only a tax nightmare, but an administrative nightmare as well. As you can see in this case, Founder would kick herself for not taking the 83(b) election.
Now that you understand how the 83(b) election works, the next trick is to not miss the deadline to file. An 83(b) election must be filed with the IRS within 30 days after the shares have been issued — no exceptions. This is one of the few things in life that you can’t go back and fix, no matter how hard you try. If you miss the 83(b) election, you miss it forever as far as those shares are concerned.