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Friday, October 12, 2012

An Introduction to 83(b) Elections

from Guarav Krishan





Typically, a startup company will allow its founders to purchase equity in the company as a way of incentivizing them to use their best efforts to grow and expand the business.  Under Section 83 of the Internal Revenue Code (the
Code"), when property is transferred to a person in connection with the performance of services the difference between (i) the fair market value of such property and (ii) the amount paid for such property is treated as ordinary income subject to all income and withholding taxes.  In and of itself this may not seem particularly problematic since most of the time the founders purchase the stock at current fair market value and therefore one may (incorrectly) conclude that no taxes would be owed under this rule.  However, most companies will require the founders’ stock to be subject to certain vesting conditions, which require the founders to remain with the company for a specified period of time or otherwise meet certain specified performance goals in order to retain the benefit of the stock they’ve purchased.  If the stock purchased by the founders is subject to such vesting conditions, then under Section 83 of the Code the difference between (a) the fair market value of the vested shares of stock as of each vesting date minus (b) the original purchase price of such vested shares of stock will be deemed to be ordinary compensation income to the founder.  This presents two problems for the founders of the company if the stock has appreciated since the date of purchase: (x) the amount of the taxes owed by the founders could be significant and (y) the founders likely have not received any cash for their shares of stock with which they can pay the income taxes.  In addition, the company is obligated to pay employment taxes on the amount of the income recognized by the founder as the stock vests if the founder is an employee.

            Fortunately, the founders can avoid this potentially costly tax outcome by filing an 83(b) election for the purchased stock.  If the founders properly file an 83(b) election, then the difference between the fair market value of the stock subject to vesting as of the date of purchase minus the purchase price for such shares will be deemed to be ordinary income and all appreciation in the value of the shares in excess of the purchase price will be treated as capital gains.  Therefore, it is almost always the case that the founders will want to file an 83(b) election in order to achieve a preferable tax outcome.  The potential downside to filing a Section 83(b) election is that the amount of the ordinary income reported with the election is not recovered if the stock is later forfeited.

            The benefit of filing an 83(b) election is best illustrated by way of a practical example.  Assume that a founder purchases 1,000,000 shares of “Startup A” stock for $1.00 per share (the fair market value for such shares on the date of purchase), which shares vest over a four-year period with 25% of the shares vesting at the end of each year. Also assume that, “Startup A” performs well over this four-year period and so, each year the price of the stock increases by $1 per share.  If the founder does not make an 83(b) election then she will recognize income as follows:

Year

Number of Shares Vesting

Fair Market Value per Share

Total Ordinary Income Recognized under §83

End of Year 1

250,000

$2

$250,000

End of Year 2

250,000

$3

$500,000

End of Year 3

250,000

$4

$750,000

End of Year 4

250,000

$5

$1,000,000

Total

1,000,000

---

$2,500,000

 

Therefore, once the shares are fully vested, the founder will have to had to pay approximately $875,000 in income taxes (assuming a 35% marginal federal tax rate), without any cash, and likely, without any ability to sell shares in order to generate cash to pay this tax obligation.  However, if the founder had filed an 83(b) election at the time of the purchase she would have realized $0 of ordinary income and would have to pay capital gains tax on the appreciation only as and when she sold such shares. 

In order to properly file an 83(b) election, the founder must:

(i) complete and sign an 83(b) election form providing the information required by the IRS;

(ii) file an original executed copy of the 83(b) election form with the IRS within 30 days after the date of the transfer;

(iii) deliver one copy of the completed and executed 83(b) election form to the company; and

(iv) retain one copy of the completed and executed 83(b) election form and file it with her federal income tax return in the tax year in which the election was made. 

Gaurav Krishan is attorney with Stubbs Alderton, and focuses on corporate transactions, including M&A, dispositions and recapitalizations, private equity transactions, and general corporate matters for both public and private clients, focusing on startup and emerging growth companies. You can reach him at gkrishan@stubbsalderton.com.


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