The Tax Effects of Filing (or Not Filing) an 83b Form
I don’t know anyone who likes paying more taxes than they have to. So, if you’re an entrepreneur and you’d like to keep more of your money, read on. Part one (the basics). All shares of stock in every company have some value, even shares in the earliest stage startup with the most nascent technology.
When you are issued shares without purchasing them at full value, the IRS treats the value in excess of the amount paid as income.
Most early stage startups issue shares of stock to founders of the company, and those founders do not pay for the shares. So, if that was the end of the story, every founder would owe some amount of tax on the value of the shares at issuance, and that tax would be due and payable in the year the shares were issued. But that isn’t the end of the story. Part two (vesting).
When early stage startup companies issue stock to founders, it is almost always subject to a vesting schedule, meaning that the company has the right to take back shares if the founder were to leave before the shares become “vested”. The purpose is to incentivize founders to remain engaged with the company long term.
Without vesting, a founder might receive a significant ownership stake in the company on day one, and then leave with that full ownership stake one day soon afterwards. Future investors are very unlikely to contribute capital to a company where so much ownership is allocated to an uninvolved former founder. The most common vesting schedule is a 4 year schedule with a 1 year cliff and monthly vesting for the remaining 3 years. The IRS is an understanding big brother, and says the stockholder won’t be taxed on shares until they vest. Sounds good, right? Wrong. Part three (the pain of taxation at vesting). Remember when we said that even shares in a super-early startup have some value? You probably thought, “yeah, but it’s worth next to nothing on day 1.” - and you’re right. But what about three years later after the company has raised $25mm and is growing and profitable? Those shares are worth a lot more, woohoo! However, because the IRS is taxing your shares on their value when they vest, you could owe substantial taxes on the shares. You might not have the available cash to pay these taxes, and if there isn’t a market yet, you can’t sell shares to pay the taxes you owe. So, what is a founder supposed to do? Part four (the magic of the 83b filing). The IRS allows the recipient of restricted shares subject to a vesting schedule to file an “83(b) election” to instruct the IRS to treat the shares as if they are not subject to a vesting schedule.
In effect, your shares are taxed at issuance at their value at the time of grant (likely a nominal amount) versus their value when they vest (after that $25mm investment round). Plus, filing an 83b form starts the one year capital gains holding period for the shares at the issuance date instead of the vesting date, which will be an added benefit when you eventually sell your shares. Virtually every startup founder that receives stock at the earliest stages of a company should file an 83b form. Here is the form and the filing instructions that we use for our company clients. And here are the basic best practices to filing an 83b form:
An 83b form must be filed with the IRS within 30 days of the issuance of the shares. No exceptions.
Stockholders should make three originals. Keep one, send two to the IRS with a return envelope self-addressed and stamped and ask for a stamped and filed copy for your records.
Check the IRS website before you submit the form to confirm that you are sending the 83b form to the appropriate IRS office address.
Send the package to the IRS return-receipt requested. This 83b form could save you a lot of money - it’s worth the extra couple of dollars to make sure you can prove it got where it was supposed to go.
If you have special circumstances you should check with your counsel and/or your tax advisor.
Part six (some examples). It’s worth illustrating just how much money founders can save by filing an 83b form with the IRS on time. Let’s assume the following:(a) You are the founder of a new startup and the company issues 1,000,000 shares to you on a normal vesting schedule (four-year vesting with a one-year cliff and monthly vesting thereafter).(b) The value of your shares is $0.00001 per share at issuance.(c) The per-share value is $1.00 at year 1, $2.00 at year 2, $3.00 at year 3, and $4.00 at year 4.(d) You sell all your shares for $5.00 per share six months after 100% of your shares vest (4.5 years after issuance).(e) Your regular income tax rate is 37%, and the capital gains rate is 20%. Example 1: If you do not file an 83(b) election
Issuance Year 1 Year 2 Year 3 Year 4 At Sale Shares vested 0 250,000 250,000 250,000 250,000 1,000,000 Income 0 $250,000 $500,000 $750,000 $1,000,000 $250,000 Capital Gains 0 $0 $0 $0 $0 $2,250,000 Tax due 0 $92,500 $185,000 $277,500 $370,000 $542,500 Total Tax: $1,467,500
Example 2: If you file an 83(b) election on time
Issuance Year 1 Year 2 Year 3 Year 4 At Sale Shares vested 0 250,000 250,000 250,000 250,000 1,000,000 Income $10.00 $0 $0 $0 $0 $0 Capital Gains $0 $0 $0 $0 $0 $4,999,990 Tax due $3.70 $0 $0 $0 $0 $999,998 Total Tax: $1,000,001.70
As you can see, filing an 83(b) form would save this founder almost $500,000, plus it allows the founder to avoid the annual tax hit that would occur without filing.Based in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in Raleigh, Durham, Chapel Hill, Wilmington, Charlotte and throughout the Southeast. We also represent venture capital funds and other investors who invest in companies located in New York, Silicon Valley and everywhere between.The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.