In our previous publications, we have drawn attention to the idea of vesting of options and reverse vesting of stock, which means that the founders of a start-up can receive stocks that they do not completely own, because a company has the right to repurchase them (in reverse vesting); or employees get the right (option) to buy the stocks in the future (in vesting). Thus, these stocks must be earned by founders or employees under certain conditions (usually, staying with the company for several years, depending on the terms of specific agreements).
In this article, we will review the options for paying taxes when acquiring such stocks and using the so-called “83(b)” under U.S. law.
The 83(b) election is a U.S. Internal Revenue Code (IRC) provision that gives a person who receives stock that is subject to a reverse vesting mechanism, which the IRS considers as “substantial risk of forfeiture,” the right to pay taxes on the fair market value of the restricted stock at the time when the stock is granted.
A Section 83(b) election may allow a start-up founder who received a stock (or any other person who holds the property that is subject to “substantial risk of forfeiture” under the IRC Section 83) to save a significant amount of taxes, because the tax in this case is based on the actual market value of the stock at the time it was issued, rather than its fair market value at the date when it vests (and released form the “substantial risk of forfeiture”); assuming the fair market value of the stock appreciate, and is actually higher when it vests, the 83(b) election can save the holder the taxes due.
Essentially, the 83(b) election allows the holder to pay one’s tax liability upfront at a low estimate, assuming that the cost of equity will increase in subsequent years. However, sometimes the filing of an 83(b) election may end up by paying taxes for a higher capital valuation if the equity value has decreased since the company was created.
In general, when a founder or employee is compensated by a stock in a company, the stock may be subject to income tax according to its value. The tax due must be paid in the actual year the stock is issued or transferred.
But sometimes, a founder acquires ownership of the stock over time, rather than at the time the company is created. For instance, that can happen in the event of a reverse vesting of stock. In that case, the tax on the value of the issued stock must be paid at the time each portion of the stock vest. So if the value of the company increases during the vesting period, the tax payable during each vesting year also increases accordingly.
However, if an 83(b) election is not filed, then when the first shares are vested and being released from the “substantial risk of forfeiture”, a founder will be required to recognize as income the full fair market value of the shares at the vesting date. If the growth of the stock value is substantial in that first year and over the next years, then the difference in tax could be significant.
An 83(b) election is a short document that the applicant sends to the IRS to notify an intent to tax property when it is received, and not when it fully vests. The 83(b) election must be sent to the Internal Revenue Service within 30 days after the stock is acquired.
While electing to use Section 83(b) usually makes sense for the initial grant of stock to a founder that is subject to a “substantial risk of forfeiture,” there are several situations when it may not be the best course of action.
Assume that a founder is worried that the value of the stock will decrease over time, then it is better to wait and recognize the lower value of the stock as it vests. Or if the stockholder does not expect to remain with the company during any of the vesting periods, then there would be no need to pay taxes on the value of stock that may not even be received in the future.
In summary, the idea of filing the 83(b) election under the Internal Revenue Code is that the individual chooses to pay income tax immediately when the property is received rather than when it is fully vested (or in no longer under the substantial risk of forfeiture) in order to make tax liabilities lower than at a later time. And this is certainly a benefit for the holder.
However, the disadvantage of an 83(b) election is that not all of the stock granted will necessarily turn into stock of value when fully vested, meaning that the payer may “overpay” the tax. In other words, a person can make a choice to pay taxes under Section 83(b) and then the property may become worthless or never vested, and as a result the taxpayer will end up paying more taxes than one should have paid.
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