With all clear on how to distribute the shares amongst the founders in the company, it is time to move ahead and talk about the taxes you will need to pay for what you own. In this case, you need to know all about the section 83(b) election. Keep reading to know more!
What is the 83(b)Election?
The 83(b) election is a requirement under the IRC (Internal Revenue Code) which offers startup founders or employees the choice to pay their taxes on the total FMV (fair market value) on restricted stock at the grant date. This 83(b) election is only applied for the equity subject to vesting.
By choosing the 83(b) election, the IRS (Internal Revenue Service) is informed to tax the elector for the ownership of the shares at the time of the grant, rather than when the stocks become vested. This means that the receiver of the shares on a vesting schedule would pay tax for the shares before they are completely vesting when they elect for the 83(b) election.
How are Vesting Shares Taxed (without the 83(b) election)?
Usually when a founder or employee gets some form of compensation of equity in a company, the stocks are subject to income tax on its value at the time. So, the fair market value of the equity at the time of the grant or transfer is used for the assessment of the tax liability. And the due tax would have to be paid in the year when the stock is granted.
There are many cases where an individual gets equity vesting over several years. This means that the person would have to stay with the company for a longer time (the vesting period) before they can get the shares for their work. So for this, the tax is usually due at the time of the vesting (after the vesting period is over) and not before that. In case the value of the company grows over time, the tax paid in each vesting year would also increase accordingly.
For instance, a founder of a company is offered 1 million shares subject to vesting at the value of $0.001 at the time the shares were granted. This means that the worth of the shares were $0.001 x number of shares = $1,000. The shares would represent 10% ownership for the founder in the company and will be vested for over 5 years. This means that the founder would get 200,000 shares every year for a period of five years.
And during each of the five vested years, he would have to pay tax on the fair market value of the 200,000 shares vested. In case the total value of the equity of the company increases to become $100,000, then the founder’s equity value would increase to $10,000. So, in this case, the tax for the first year would be deducted from ($10,000 – $1,000) x 20% which would be ($100,000 – $10,000) x 10% x 20% = $1,800.
- 20% represents the 5-year vesting period for the co-founder’s 1 million shares (200,000 shares/1 million shares)
- 10% is the ownership stake of the founder
- $10,000 is the value of the firm at inception or the book value
- $100,000 is the Year 1 value of the firm
If during the second year, the stock value increases again to $500,000, the founder would have to pay taxes on ($500,000 – $10,000) x 10% x 20% = $9,800. And in the third year, the value increases to $1 million, the tax liability would also increase to ($1 million – $10,000) x 10% x 20% = $19,800.
If the value keeps increasing in the next two years as well, the taxable income would also increase for each year. And if the founder gets the shares to then sell for a profit later on, the profit gained would be subject to capital gains tax.
83(b) Tax Strategy
Getting back to the 83(b) tax strategy. This election allows the founder to have a choice where they can pay tax on the equity upfront before the vesting period starts. So, if the founder elects this tax strategy, they would only need to pay tax on the book value of $1,000. Additionally, the IRS is notified about the choice made by the elector to report the difference between the amount paid for the stock and the FMV of the shares as taxable income.
The share value during the 5 year vesting period would not play a factor as they would not pay additional tax to retain the vested shares. Nonetheless, in case the founder sells the shares for a profit after receiving the shares, the capital gains tax would be applied.
Using the same example shared above, in case the founder makes the 83(b) election to pay the taxes on the value of the stock upon issuance, the tax assessment would be $1,000 only. And now, in case the founder sells the stock of his company after 10 years for about $250,000, he would have to pay the capital gain tax on $249,000 ($250,000 – $1,000 = $249,000), and not income tax on this amount.
Just to be clear, choosing the 83(b) election makes sense only when the elector is sure that the value of the shares would increase in the following years. Additionally, in case the amount of income reported is small at the grant date, the 83(b) election would be highly beneficial.
On the other hand, for a different situation where the 83(b) election is triggered and the value of the company falls, then the taxpayer would have overpaid taxes for the shares that have very low value or are worthless. Regrettably, the IRS does not approve of the overpayment claim of taxes under the 83(b) election.
For instance, let us take a founder whose total tax liability upfront after filing for the 83(b) election is $50,000. And as the vesting year passes by, the stock value declines. It would have cost the founder a lot more than it should. And it would have been better to avoid the 83(b) election as they would have paid much less based on the value of the shares during that vesting year.
Another example where the 83(b) election can turn out to be a disadvantage is when the founder leaves the company before the vesting period is over. In this case, the founder would have paid taxes on the shares that would never be obtained.
83(b) Form Requirements
For filing for the 83(b) election, you will have to send all the documents to the IRS within 30 days of the issuance. Additionally, the recipient would have to notify the IRS about the election by submitting a copy of the completed election form to their employer and also send a copy in their annual tax return. To understand all the instructions for the 83(b) election, read the next section.
Instructions for filing 83(b) Election
These instructions are just an idea of how you would need to file the 83(b) election. So before you file for the election, do take help from your lawyer or a professional to avoid any mistakes.
Also it should be noted that the election has to be filed within 30 days of the issuance with the IRS. If you fail to file within this time, you will not be able to elect for it later on, and you will have to pay tax based on the vesting schedule of the shares.
Here are the instructions for the filing of the 83(b) election:
- Make three copies of the completed and signed election form. Along with this, make one copy of the IRS cover letter.
- Send the original completed and signed election form with the cover letter, the copy of the cover letter and a self-addressed stamped return envelope to the IRS center. It is important to send the election via certified mail and get the return receipt for it. Ensure that the certified mail number is written on the cover letter as well before sending it.
Note: Just know that even if there is an address of the IRS shared in the forms below, you should always verify it. To do this, search for “where to file” on the IRS website or by calling 1 (800) 829-1040.
- Send one copy of the completed election form to the company from where you received the shares.
- There might be a state law where you might need to attach a copy of the completed election form to your state personal income tax returns when you file in the year the election was made.
Note: Take the help of a professional tax advisor. They would help you know if you need to send the copy with your personal income tax form or not.
- Keep one copy of the completed election form with your permanent personal records.
Note: An additional copy of the completed election form has to be delivered to the transferee of the property if the service provider and the transferee are different people.
All-in-all, ensure that you consider every factor before you move ahead and file for the 83(b) election. Weigh the options on how this election will affect your income and capital gains tax on your shares, and what might happen in the future to the company’s value. If you are sure that the company would grow, you can file for the election. To know more, check out the other knowledge-based articles or visit the main menu here!