“Did you file your 83(b)?”
If your client’s answer is no but should have been yes, an array of unwanted consequences may already be in process. But all hope may not be lost.
The Sec. 83(b) election often comes up when a company’s founder or other employee receives stock or other equity that is subject to vesting — that is, conditions may require the stock to be forfeited, e.g., if the founder or other employee stops working for the company.
The default tax rule under Sec. 83 for stock subject to vesting is that no income has to be recognized upon grant but rather will be recognized when the stock vests, at the value at the time of vesting. For example, consider a private company’s founder who was issued 1 million shares of the company’s stock with a value at the time of issuance of $0.0001 per share (not an unusual valuation for an early-stage startup company). If the company experiences dramatic growth, the taxes incurred upon vesting may be dramatic as well. In this example, if 25% of the stock vests after one year when the value is $0.10 per share, then at the end of that year, the founder would owe tax on $25,000 of compensation. Then, assuming a simple annual vesting schedule for the next three years, the founder would recognize more income every year as the vesting hurdles are met (and if the company is doing well and growing fast, the income will be much greater than $25,000 per year).
Contrast this with what happens if a Sec. 83(b) election is made. Then, instead of applying the default tax rule, the recipient is taxed at the time of the grant at its value at that time. In our example, the founder would owe tax on $100 (the total value of the stock) at the time of the grant, but vesting becomes a nonevent for tax purposes (i.e., no additional tax is incurred).
While the recipient of the stock will probably be the one most distraught over the tax consequences resulting from missing a Sec. 83(b) election, a missed election will place a burden on the company as well. The company will need to decide on a value for newly vested stock at every vesting date and will need to properly report that amount as compensation. However, on the bright side, the company can generally take a deduction for that amount.
Particularly for stock in early-stage startup companies that have low valuations, the choice to make the election is a no-brainer. However, it is one of those tasks easily overlooked in the excitement and bustle of starting a company or closing on an investment, and there is generally only a 30-day window during which to notify the IRS of the election.
As noted above, however, there is hope for a taxpayer who has missed making a Sec. 83(b) election, although there are often collateral consequences to consider.
First, if an employee thinks he or she is late in making the election, make sure the stock was really issued and the 30-day window has passed. Read the grant agreement carefully — sometimes a grant is conditioned on an event that did not occur or that did not occur until later than intended. For example, the employee may have been required to pay the company a nominal amount for its stock, which he or she never did, or the board of directors was required to approve the grant but did not do it on time. In such a case, it may be possible to take the position that the stock was not actually issued and re-grant it as of the current day. While regranting the stock will necessitate using the current valuation of the company when the stock is regranted, it will also start a new 30-day window for the recipient to file the Sec. 83(b) election.
If the 30-day window has truly passed, there are still partial fixes, if the employee and company are willing to work together. One simple approach is to amend the grant and have the stock vest immediately. This causes the recipient to recognize income equal to the current fair market value (FMV) of the newly vested shares, but no further income would need to be recognized until disposition of the shares. While this mostly fixes the tax problem, eliminating the vesting changes the business deal, potentially materially.
A more sophisticated approach takes advantage of the fact that, under the tax law, the stock will be taxable to the employee at the earlier of the time the stock is not subject to a substantial risk of forfeiture or when the stock is substantially vested; i.e., when the employee can transfer the stock to a third party without the vesting restrictions being attached after the transfer. By amending the arrangement to give the employee such a transfer right, the tax can be accelerated to the time of the amendment and based on the FMV of the stock at that time, much as if the stock’s vesting were accelerated. The transfer does not actually have to take place — it is enough that the employee has the right.
Note that as long as the employee is the owner of the stock, the vesting restrictions remain effective. The company can also add contractual obligations by the employee to discourage the employee from transferring the stock and then leaving the company — for example, by requiring the employee to pay a penalty equal to the FMV of the stock that would have been forfeited if the employee had held on to the stock but left the company before all vesting conditions were met.
The very best solution is to make a Sec. 83(b) election and timely inform the IRS of the election, thus avoiding the problem in the first place. But for those times when a Sec. 83(b) election has been missed, remind clients that not all hope is lost.
— T.J. Wilkinson, J.D., LL.M., is a shareholder and co-chair of the Tax Law Practice Group at Shulman Rogers Law Firm in Potomac, Md. To comment on this article or to suggest an idea for another article, contact Paul Bonner, a senior editor with the Association’s Magazines & Newsletters team, at Paul.Bonner@aicpa-cima.com.