An “83(b) election” is a tax election made with the IRS that, when timely filed, saves many startup founders a lot of money in federal taxes. The IRS requires that this filing be made within 30 days after the grant of stock subject to vesting or other “substantial risk of forfeiture.” Missing this deadline has serious consequences for both a stockholder and the issuing company. It’s incredibly important and beneficial to file an 83(b) election on time. However, if a stockholder misses the deadline, there may be ways to remedy the situation.
How are stock grants generally taxed?
Almost all income is subject to taxation, and stock grants are no exception. Generally, when a company grants stock to another party without payment, the equity grant is considered compensation, and the recipient is potentially subject to income taxes.
At the early stages of a company, this risk of taxation is relatively insignificant. For example, if the value of a founder’s initial stock grant is reasonably set at $0.00001, even a large number of shares equates to little effective compensation. One common challenge to this situation, however, arises with respect to stock grants that are subject to what the Internal Revenue Services calls “a substantial risk of forfeiture”, meaning the founder or other stockholder might be required to surrender all or a portion of their shares at some point in the future under certain circumstances.
With startups, this situation arises in the case of vesting schedules and “restricted stock.” With respect to stock, vesting generally implies the issuing company retains certain rights to repurchase that stock from the holder (usually a founder, employee, or service provider) if that holder is no longer engaged by or affiliated with the company. The company’s repurchase rights are often subject to a vesting schedule, meaning the right lapses over time or upon the satisfaction of certain preset milestones. The “repurchasable” stock is referred to as “unvested stock,” and any stock over which the company’s right to repurchase has lapsed is referred to as “vested stock.” Unvested stock is considered subject to a “substantial risk of forfeiture.”
The IRS’s default rule is to tax stock compensation on the date of grant. However, the IRS (i) taxes unvested stock (and stock that might otherwise be subject to a substantial risk of forfeiture) on the date the stock becomes vested, and (ii) calculates the value of compensation for taxes purposes as of that same date. The result is a potentially massive tax bill for unvested stock, especially if a vesting schedule lasts for years and the value of your company (and therefore the founder’s stock) increases.
This is a risk for both the stockholder and the issuing company. The stockholder will be required to find funds to pay for these tax obligations. And, if a stockholder is considered an employee, the company may be required to withhold certain taxes on the stockholder’s behalf for the compensation (in the form of stock) paid by the company to the stockholder. This means that the company will need to comply with burdensome withholding requirements each time any shares of the stock vest. The company must make a reasonable determination of the fair market value of the shares as of that vested date, calculate appropriate taxes to be withheld for the stockholder with respect to the value of the vested stock on that date, and actually withhold such amounts. Failing to timely address these tax considerations can create significant challenges for the stockholder and the company and often comes with hefty penalties and fines.
What’s the benefit of an 83(b) election?
A timely-filed “83(b) election” provides significant relief here. Stock covered by an 83(b) election is taxed using the value of the stock on the date it was initially issued (rather than on the date it vests). This means, if your stock is initially worth $0.00001 per share, that’s the price per share the IRS will use to calculate your income from the stock grant, even if that stock vests over time.
83(b) elections must be filed with the appropriate IRS office within 30 days of the initial grant of the stock. This is an arbitrary deadline without any wiggle room. So, if you receive stock subject to vesting, file your 83(b) election immediately. If your company is issuing restricted stock, stay on top of your stock recipients, help them properly file their 83(b) elections, and consider conditioning any grant of restricted stock upon the stockholder’s successful filing of an 83(b) election.
What if a stockholder misses an 83(b) election?
If a stockholder fails to timely file an 83(b) election, there might be ways to save the stockholder and the issuing company from unfavorable tax consequences. We outline three options below. Note, if significant time has passed since the stock was issued and some unvested stock has since vested, the stockholder and the company may still owe some back taxes. Nevertheless, the below options can be useful to eliminate or minimize ongoing tax obligations as the stock continues to vest.
1. Cancel the Stock Grant and Issue New Stock
If there are few people on the cap table, you might consider just canceling the initial grant and issuing alternative stock to a founder. There are three main concerns here. First, if there are multiple stockholders, you may create complications about who owns what. Make sure everyone is on the same page and that you properly document the cancellation of the original stock and issuance of the new grant. Second, be wary of backdating stock grants, particularly grants that occurred in a prior tax year, as the company’s value may have changed during the time and the stockholder and/or company may have already incurred tax liabilities for a certain tax period. (Note: the stock we’re talking about here is different from stock options. NEVER backdate an option grant.) Finally, if the IRS ever audited a stockholder or your company, they may consider the second stock grant a sham transaction and still assess tax liabilities based on the original stock grant. Consider using a different vesting schedule or a different number of shares for the second stock grant, which can help distinguish this as a separate rather than replacement grant.
2. Amend the Vesting Schedule to Repurchase at “Fair Market Value”
As noted above, 83(b) elections are only necessary for stock that is subject to a “substantial risk of forfeiture,” such as a repurchase right in favor of the company. The forfeiture risk here is that the company will buy back the stock if the stockholder is no longer engaged with the company.
Even if a stock grant is subject to vesting, certain rights might eliminate the “substantial risk of forfeiture” label from the IRS’s perspective. One way to achieve this is to adjust the price at which the company can repurchase any unvested stock. An ordinary vesting schedule allows the company to repurchase the stock at the original purchase price. However, if the company and the stockholder adjust this repurchase price to the “fair market value” of the stock at the time of repurchase, there is no substantial risk of forfeiture in the IRS’s eyes. The stockholder would owe taxes immediately upon the stock grant, when the tax is low and would not need to file an 83(b) election for the stock.
After a normal stock grant has been made to a founder, and that founder has missed her 83(b) deadline, the company and the founder can simply amend the stock grant to change the repurchase price from par value to fair market value.
Note, however, that this approach creates a financial problem for the company. If the founder leaves during her vesting period, the company may need to shell out real money to buy back the stock, instead of its usual right to repurchase the stock for a nominal value. Future investors may raise this as an issue when conducting their due diligence.
3. Cancel the Vesting Schedule and Apply a Different Vesting Schedule Later
The company and the stockholder can amend the stock agreement to remove the vesting schedule entirely. Without vesting, there is no substantial risk of forfeiture, and the stock grant will be taxed upon grant (at a relatively low amount).
The risk here is that the founder can leave the company any time and keep all of the stock. However, the company can minimize this risk by entering into a separate vesting schedule with the stockholder down the road (assuming the founder willingly enters into that separate agreement). The company shouldn’t re-apply vesting right away. If it did, the IRS might consider the cancellation of the original vesting schedule a sham. Instead, the company should wait a significant amount of time to clearly separate the stock grant from the application of a subsequent vesting schedule. That way, the stockholder can take the position that the updated vesting schedule is a new agreement that didn’t necessitate an 83(b) filing back when the stock was originally granted. Many tax attorneys consider six (6) months to be enough time, but there’s no clear rule. Talk to your tax advisors to clarify the best approach for your situation. Assuming enough time has passed, the stockholder should not have to file an 83(b) election event after the new vesting schedule is effective.
83(b) elections provide a critical opportunity for stockholders with unvested stock to significantly minimize their tax liability. Failing to timely file an 83(b) election creates tax risks for both the stockholder and the issuing company. Unfortunately, in some situations, a stockholder and a company simply cannot remedy a failed 83(b) filing or it may be impractical to do so. Fortunately, however, if a stockholder doesn’t file its 83(b) election within the 30-day period, there are a few potential ways to remedy the situation or at least minimize future tax obligations for the stockholder and the company.
Any situation involving taxes involves a nuanced assessment of complex tax laws and how those laws apply to a company’s or an individual’s specific situation. Make sure to talk to your and your company’s tax advisors about how to address considerations related to 83(b) elections before making any decisions.
Picture on the top is by Markus Winkler and is in the public domain.
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