How Important is it to File a Section 83(b) Election in a Startup?

Section 83(b) of the Internal Revenue Code is primarily used in instances of stock issuances. This provision is applicable to company owners who receive equity as part of their compensation. The Internal Revenue Service (IRS) requires that an individual report any income recognized in a particular year. Included in the definition of income is equity received as compensation for services rendered to a company. Pursuant to Internal Revenue Code (IRC) section 83(a), the individual receiving the equity will report the value of the equity as compensation when they become owner of the equity. The equity may be subject to a vesting schedule and restricted from immediate sale. Because the equity holder may lose the unvested shares under certain circumstances, it makes the shares subject to a “substantial risk of forfeiture”. In this scenario, the employee has not necessarily received ownership of the equity for purposes of taxation. Section 83(b), discussed below, offers the shareholder the opportunity to avoid negative tax consequences.

Vesting Schedule and Restricted Shares

Stock grants are contract that contain numerous provisions. In most cases, the employee receiving the stock as compensation may not fully own the stock granted to them. That is, stock granted to employees is often subject to restrictions and a vesting schedule. This means that the stock cannot be immediately sold. If it cannot be immediately sold, it shareholder cannot cash out of the stock. Also, the shareholder to does not become full owner of the stock until it vests in them. The stock will generally vest along a timeline (generally over 4 years) or upon the company meeting certain performance metrics. Also, often times, none of the stock will vest until a specified period of time has passed. Once that period has passed (generally 12 months), a specific percentage of the stock will vest (generally 25% of stock granted). This is known as a “cliff”. The purpose of this arrangement is to make certain an employee stays with the company and remains loyal after receipt of the stock grant. It would not be good for the company for the employee to immediately leave the company holding the stock.

Tax Consequences of Section 83(a)

Restricted equity that is subject to a vesting schedule will not vest ownership in the member until some time in the future. The effect of the member’s equity ownership being subject to risk of forfeiture (restrictions and vesting schedule) is that, under Section 83(a) the employee does not immediately recognize the equity grant as income. The thinking is that the member is not full owner of the equity. This is a real problem if the employee assumes that the value of the equity awarded is going to rise. The reason regards taxation.

Any increase in the value of an equity holder's (business owner's) interest is not subject to taxation until or unless the stock is sold or traded. This allows for tax deferment (until sale). If the equity is subject to vesting, the employee is required to recognize the value of the equity as income at the time that it vests. This means that, if the equity has risen in value since the time of grant, the employee must recognize the higher value as income at the time of vesting. This is not favorable, as the amount of taxes on income is generally higher than the taxes on capital gains. Further, this option does not allow for deferral of taxation until the equity is sold.

Benefits of Section 83(b)

The savior for the employee is IRC section 83(b). This provision allows the employee to elect to recognize the full value of the granted equity immediately. That is, the employee does not have to wait until the equity interest fully vests to recognize the value of the equity as income. Thus, the employee recognizes the equity as income when it is lower in value. When it rises in value in the future, it is taxed at a capital gains rate and it is not taxable until the equity is sold.