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- When stock is part of your compensation, you owe taxes on it just like any other income.
- With many startup founders, the stock grant is subject to a vesting agreement. As such, the founder pays tax on the stock once vesting is satisfied. If you don’t satisfy your vesting period, then you forfeit (or give up) your stock.
- Enter the Section 83b election. This election, which the Internal Revenue Code governs, allows founders and other key startup employees to pay income taxes when they first receive the stock before it vests. Section 83b will enable you to essentially prepay your taxes before the stock rises in value, increasing your tax liability.
- Ideally, by prepaying your taxes, you’re paying taxes on a lower stock valuation and hoping that the stock will increase in value over time.
- An 83b election would allow you to take advantage of lower capital gains tax rates. As soon as your stock is subject to tax, the clock starts running to apply capital gains. This means that any appreciation in your stock’s value will be taxed at the capital gains rate, not at the ordinary income rate.
- Once you complete your Section 83b form, you must file it with the IRS no later than 30 days after your stock grant date.
To attract and retain senior-level talent, many startups reward employees with executive compensation. This type of compensation often includes stock that is subject to a vesting schedule, depending on the company’s growth, retention, and succession goals.
However, as with any stock award, it’s tricky to determine the long-term tax implications. When stock is part of your compensation, you owe taxes on it just like any other income. When the Internal Revenue Service (IRS) calculates the tax on your stock, it bases your taxable amount on the stock's fair market value at the time it’s transferred to you. However, the tax is not due until the year that the stock’s equity is actually transferred to you.
The tricky part is when to have your stock transferred to you -- creating a taxable event. Knowing if the startup will flourish, thus causing the share price to skyrocket or whether the growth will be slow and steady, there’s risk in when to redeem stock and how that redemption impacts your taxes.
With many startup founders, the stock grant is subject to a vesting agreement. As such, the founder pays tax on the stock once vesting is satisfied. If you don’t satisfy your vesting period, then you forfeit (or give up) your stock. However, as mentioned above, if the startup is highly successful and the stock increases in value before the vesting schedule is met, the founder will pay much more in taxes.
Enter the Section 83b election. This election, which the Internal Revenue Code governs, allows founders and other key employees to pay income taxes when they first receive the stock before it vests. Section 83b allows you to essentially prepay your taxes before the stock rises in value and increases your tax liability.
What is an 83b Election?
When the founder or a key employee receives new stock benefits, they will also receive a Section 83b election on the granted stock. This notice gives you the option to pay tax on the entire amount when initially received at the present value. So, essentially, you’re paying all the owed tax upfront when the stock is granted.
Ideally, by prepaying your taxes, you’re paying taxes on a lower stock valuation and hoping that the stock will increase in value over time. However, this tax strategy can backfire on you if, for example, the stock does not increase over time but decreases. If this is the case, then by prepaying your taxes on the stock at the time of grant, you have essentially overpaid, as the stock’s value was at its highest at the time of grant.
If elected, the Section 83b notice must be sent to the IRS within 30 days after the issuance of the stock. This notice lets the IRS know that you have decided to pay the tax on the stock when granted and not at the time of vesting. Your employees must file a copy with you (as their employer) as well, notifying you of their decision. Note that a Section 83b election is typically irrevocable once made.
Breaking Down the Taxes Owed: Scenario #1
In the U.S., different types of tax rates exist. For example, in 2021, the maximum ordinary income tax rate is 37 percent. The maximum long-term capital gains rate in 2021 is 20 percent. Because these tax rates are graduated, depending upon your situation, you may pay a lower rate than these stated maximum rates. However, no matter what, your capital gains tax rate will always be lower than your ordinary tax rate.
Let’s see how these tax rates apply to stock that is subject to a vesting schedule (otherwise known as restricted stock) by looking at the following example provided by the international law firm Cooley LLP:
“Assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant (if a Section 83(b) election is filed), or at vesting (if no Section 83(b) election is filed), in each case at the applicable ordinary income tax rate. When you later sell your stock, assuming it’s been more than one year from the date of grant (if a Section 83(b) election is filed), or more than one year from the date of vesting (if no Section 83(b) election is filed), the additional gain will be taxed at the applicable long-term capital gains rate. Because the long-term capital gains rate will be lower, the goal here is to get as much of your gain as possible taxed using that rate, rather than the ordinary income tax rate.”
Breaking Down the Taxes Owed: Scenario #2
Let’s now look at a second example, provided by the international investment bank and financial services company Robert W. Baird & Co.:
“Here’s an example of how much of a difference this can make. Assume a brand-new company with two founders who are granted 1,000 shares, with a price at founding of 1 cent, on a two-year vesting plan. Their income tax rate is 33 percent, and the long-term capital gains rate is 20 percent. Here’s how this would play out with and without an 83(b):”
Chart by Baird.
“So not only does the 83(b) election in this example save the founder $10,000, but nearly the entire burden is shifted into the final year when they are likely to be more capable of handling a big tax bite,” according to Baird.
Where to File an 83b?
Now let’s look at where to send an 83b election. Once you complete your Section 83b form, you must file it with the IRS no later than 30 days after your stock grant date. Mail the completed form to the IRS, preferably through certified mail, return receipt, at the same address where you file your taxes. If you’re unsure of this address, you can check the IRS’s website to provide you with the correct address.
Also, your employees will need to mail a copy of the form to you, also preferably through certified mail, return receipt. It is no longer necessary to attach a copy of your 83b election to your taxes, which was required in the past. However, it’s a good idea to keep a copy in case you ever face an IRS audit.
What Happens If I Don’t File an 83b Election Timely?
For a Section 83b notice to be considered filed timely, it must be filed with the IRS no later than 30 days after the grant of the stock. If you fail to meet this deadline, then your 83b election is not considered filed, even if you miss the deadline by one day.
Under the IRS rules, unless you file your 83b election timely, you will be taxed on the stock's fair market value when it becomes vested. This fair market value will be treated as compensation subject to ordinary income tax rates and any required income and employment tax withholding. The startup should report the amount of compensation attributable to the vested stock on the founder’s or key employee’s Form W-2.
If your startup fails to report the compensation or withhold applicable taxes from the compensation, it could be subject to federal penalties for improper tax reporting and under-withholding. To fix this issue, you or your key employee would have to re-file tax returns for all years impacted by the failure.
How to Report an 83b Election on a Tax Return
If your Section 83b election is made in a timely manner, then you’ll need to report the fair market value of your stock award on your taxes for the tax year in which the election is made. To do this, the startup must report the fair market value on the founder or key employee’s Form W-2, in Box 1 or on Form 1099-NEC. After your stock fully vests, the startup will report the gains or losses from any future sales on Form 1099-B.
Why Should Startups Care?
Let’s examine when it is beneficial to file a Section 83b election and when it’s not. By answering these questions, we can get to the root of why startups should care about this particular tax form.
If you are a founder of a startup with no real value, and you’ve locked into a multi-year vesting agreement, if you prepay your tax by filing an 83b election, your taxes would be based on the fair market value at that time — which is minimal at best.
Additionally, an 83b election would allow you to take advantage of lower capital gains tax rates. As soon as your stock is subject to tax, the clock starts running to apply capital gains. This means that any appreciation in your stock’s value will be taxed at the capital gains rate, not at the ordinary income rate.
On the other hand, if you don’t file your 83b election, your capital gains clock doesn’t begin ticking until one year after your vesting date. As the founder, you are tasked with determining the value of shares each time shares vest, which can be complicated, especially for a startup when valuation is not yet firmly established.
However, there are some instances in which an 83b election may not be the best course of action for startup founders. For example, if you expect the stock to decrease, prepaying taxes would not be financially prudent. If you aren’t planning on staying with the startup throughout your vesting period, then you shouldn’t prepay your taxes, as you have forfeited your stock.
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