FAQ - Startup Business 004

Startup Law 101 Series - What is an 83(b) election and how does it work in practice?

Introduction

Founders in a startup ought to have a working knowledge of the 83(b) election and this faq seeks to give it to them.

This is a complex tax area and what is presented here is intended only to give a general picture of how 83(b) works. Work with skilled tax professionals in this area to avoid the landmines.

Here is the working rule for founders: 83(b) applies only where a founder owns stock and can potentially forfeit its economic value. Where these conditions exist, it is normally vital that a founder file the 83(b) election within 30 days of getting the stock grant or face potentially bad tax consequences.

That's the general picture. The tax theory and a more detailed explanation follows.

IRC Section 83 Applies to Service Providers Who Receive Property in Exchange for Services

Section 83(b) is part of Internal Revenue Code section 83, which specifies how service providers who receive property in exchange for their services are to be taxed on the value of that property.

Section 83(b) is intimately connected with section 83(a) and works really only to modify certain tax consequences that would otherwise apply to service providers under 83(a).

Therefore, 83(b) cannot really be understood without a basic understanding of 83(a).

Section 83(a) Specifies How and When Such Service-Related Income Is Taxed

Under 83(a), if I get property in exchange for my services, I pay tax on the excess of the fair market value of that property over what I paid for it.

Section 83(a) applies, then, to service providers who take property as payment for services. Who is the major service provider in a startup? No, it is not the outside consultant. It is the founder who works for sweat equity.

But let us take the cases in sequence.

If I am a consultant, and I get $5,000 worth of stock for my work done for a startup, I pay tax on $5,000 worth of service income - that is, on the difference between the worth of the stock ($5,000) and what I paid for it ($-0-). That difference is taxable to me.

So far so good. That much is intuitive.

But 83(a) is more complex than that.

The founder who has to earn his shares over time is also treated by the IRS as a service provider under 83(a). The founder may pay nominal cash for the shares and may own them, but as long as that ownership can be forfeited when the founder’s service relationship to the startup is terminated, the IRS sees the stock as having been granted in exchange for services.

Thus, founder grants that must be earned out (i.e., are subject to a risk of forfeiture) fall within and are subject to tax under 83(a).

But 83(a) does not impose an immediate tax on such grants at the time they are made. It has a special rule that taxes such grants only when they are no longer subject to a "substantial risk of forfeiture."

It is this special rule that creates traps for the unwary in the startup context.

The Nightmare Tax Scenario for Founders

Let's assume that a founder is granted 2 million shares at $.001 per share and pays $2,000 for them. The shares vest ratably over 4 years at the rate of 1/48th per month. How does 83(a) apply to this scenario? Under 83(a), the tax authorities see the grant initially as being 100% "subject to a substantial risk of forfeiture." Thus, no tax arises at the outset. But what then happens each month as 1/48th of the shares vest? Well, those shares are no longer subject to any risk of forfeiture as they vest. Under 83(a), then, each incremental vesting event creates a potentially taxable event for the founder holding such shares.

The risks to the founder may be slight at first when the stock remains priced by the company at the $.001 per share level. But what happens on first funding? Of course, the price of the stock goes up, often dramatically. Let’s say, after a Series A round, the company prices its common stock at $.20 per share. Once that happens, under 83(a) the founder holding the original grant is required to pay tax at each of his vesting points.

How is he taxed? On the difference between the then fair market value of the stock which has just vested (because the forfeiture restrictions lapsed as to that stock), on the one hand, and the price he paid for that stock, on the other. In our example, this would mean the founder realizes taxable income on the difference between $.20 per share and $.001 per share for each of the shares that vest each month. If another funding occurs, and the common stock is re-priced to $1.00 per share, then all of the founder’s shares that vest after that re-pricing event trigger a tax on the difference between $1.00 per share and $.001 per share. In other words, the founder finds himself in the middle of a potential tax nightmare. With each of his multiple remaining vesting points, he faces a new and potentially large tax hit. He would have 12 taxable events during the final year alone of his vesting cycle and (assuming the common stock were valued at $1.00 per share during that period) would realize taxable income of just a shade under $500,000 - all for the privilege of holding a piece of paper which he could not liquidate even if he tried!

With this background, we can understand the importance and the essence of an 83(b) election.

Section 83(b) Comes to the Rescue

While 83(a) sets out the general rules for how service providers are taxed when they exchange services for stock, 83(b) gives them an out from the nightmare tax scenario just noted.

Under 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can make a one-time election to have his entire interest taxed once-and-for-all at inception instead of having it taxed incrementally over time as the restrictions on forfeiture lapse.

This means that, if the founder mentioned above makes a timely 83(b) election on his 2 million share grant, he elects to pay tax on the difference, as of the date of grant, between the fair market value of the property received (i.e., the stock, valued at $.001 per share), on the one hand, and the amount he paid for it ($.001 per share), on the other. In other words, the founder will pay tax on the difference between the $2,000 that the stock is worth and the $2,000 he paid for it. Since there is no difference between the two, the tax is $-0-. This 83(b) process is in lieu of the 83(a) treatment that would otherwise apply and eliminates the nightmare tax scenario discussed above.

With the 83(b) election once made, the founder pays no tax on the grant at inception and incurs no taxable income as the shares vest over time. His holding period commences at inception for capital gains purposes and the only tax that would apply to such shares would be a capital gains tax at the time of sale.

So much for theory.

Tips for How 83(b) Applies in Practice

What does this mean in practice for founders?

1. Many founders routinely assume they need to do 83(b) filings in connection with their stock grants because "that is how startups work." In fact, 83(b) filings are only required in cases where the founder grants consist of so-called "restricted stock," which is a form of stock where the founder’s stock is subject to forfeiture on termination of his service relationship with the company.

2. If unrestricted stock grants are made to founders or others, 83(b) elections do not apply because the stock is not subject to a substantial risk of forfeiture.

3. While not often used in startups, in conventional buy-sell agreements, if a company can buy back even the vested stock of a departing founder at its fair market value on termination of a service relationship, 83(b) doesn't apply. If the buy-back is at fair market value, there is no substantial risk of forfeiture of the economic value of the stock. Thus, no 83(b) filing is necessary.

4. When a startup grants stock options to its key people, vesting is almost invariably used. Options in themselves are subject to a complex set of tax rules but 83(b) has no bearing on any of them except for one special case. If options are granted to key people who are given the right to exercise them early, and such right is in fact exercised, such recipients will get stock that is subject to forfeiture in the event they do not earn it out through a prescribed period of service. Because of the risk of forfeiture, an 83(b) election needs to be filed at the time such options are exercised or these recipients may wind up being taxed incrementally at every vesting point, just as described in the example above with the founder. Apart from this special case of early-exercise options, 83(b) does not apply to stock options.

5. Not every 83(b) election will wind up benefitting the service provider. Sometimes an employee in a mature startup is granted restricted stock at a steeply discounted price and that employee, by filing an 83(b) election, elects to pay an immediate tax on the spread between the market value of the stock and the discounted price paid. During the bubble era, such grants were often made anticipating that the recipient would profit after a company went public. In such a case, the recipient may wind up paying a substantial tax in connection with making the 83(b) election - a tax paid, in essence, for the privilege of holding a piece of paper. If the company then fails, the 83(b) election in such a case can lead to payment of a gratuitously high tax for nothing (a tax payment which is not deductable either). An 83(b) election needs to be made very carefully whenever a significant tax becomes due upon its making.

6. Procedurally, an 83(b) election must be made within 30 days of the date of grant. This is done by a filing with the IRS. The election must be signed by the recipient and any spouse. The taxpayer must also file a copy of the 83(b) election with his tax return for that year. These rules are strict and must be complied with to the letter.

Conclusion - Use Professionals to Help You Do It Right

That ends our tour for the benefit of giving the founder a bird's-eye view of the 83(b) election. Again, this is by no means complete and nothing is safe in this area unless done under the supervision of a good business attorney. Use this for your working knowledge and then make sure to do it right by working with competent professionals to help you implement the key steps.

G.G.

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