Individuals who own equity in a startup face uniquely complicated tax issues that require efficient strategies to minimize immediate and future tax liability. For example, with equity compensation (whether stock options, restricted stock, or any other form), the date that income is recognized for tax purposes is tremendously important. The Internal Revenue Code (IRC) has specific requirements for taxpayers who own stock in companies, and places the burden on these individuals to submit relevant tax forms in a timely manner to maintain compliance or receive tax benefits. One relevant provision for founders and early hires at startups is Section 83(b) of the IRC, which allows a taxpayer to inform the IRS that the taxpayer desires to immediately recognize the entire value of stock held in a corporation, regardless of vesting. Filing this election requires promptness to help minimize your tax burden, as the IRS strictly adheres to a 30-day deadline from the date the stock is granted or obtained.

Section 83(a) of the Internal Revenue Code states that, by default, the IRS recognizes the exchange of property for services as income at the time the stock entirely vests for tax purposes. The taxable income is determined by taking the fair market value of the stock at the time of vesting and the owner of the stock will owe taxes on that amount. Any appreciation that occurs in the interim of the vesting and holding period is subject to tax treatment. 

This would have potentially expensive tax consequences for startups and their equity holders. For instance, individuals that own shares of a company that experiences explosive growth in its fair market value per share could owe a substantial amount in taxes without experiencing a liquidity event that allows them to afford the tax bill. This is problematic for founders or other equity holders who have a large portion of their net worth tied up in the stock, and are less liquid. In this case, the founder might not have any cash available to pay the taxes owed to the IRS.

Using an 83(b) election, an individual can pay taxes on any income generated earlier and before the shares appreciate in value.

The IRS later drafted a potentially more advantageous method of recognizing stock received as income for tax purposes, which helped address this issue. For equity that is subject to vesting, such as restricted stock or early-exercised stock options, Section 83(b) of the Internal Revenue Code provides a method to recognize all of the 83(a) stock at the outset of the grant as opposed to over time as it vests. Therefore, using an 83(b) election, an individual can pay taxes on any income generated earlier and before the shares appreciate in value. If the stockholder intends to sell the shares at a later date, they would still be responsible for recognizing capital gains, but the interim tax liability is deferred. Methods for managing capital gains are available to startups, founders, and early hires, and will be addressed in a subsequent Insight. 

Section 83(b) elections can be submitted as early as the incorporation of the company.  Generally, the filer submits an election notifying the IRS office that the taxpayer intends to pay taxes on their shares at the time of the stock grant as opposed to when the stock vests. For the restricted common stock typically issued to founders and early hires, the value of these shares may be a fraction of a penny per share, drastically minimizing interim tax liability. 

Once the restricted shares of the corporation are issued to the taxpayer, the taxpayer has to file the 83(b) election within 30 days. The 83(b) election means that the taxpayer pays their tax liability at the outset of incorporation, which is great news if the stock ultimately appreciates. The risk, of course, is that there is no guarantee that the stock will appreciate in the following years after the grant. Therefore, by utilizing an 83(b) election, the taxpayer can possibly overpay in taxes for the shares if recognized and filed later in the life cycle of a startup. Further, if the taxpayer pays taxes on all of the stock before it vests and later sells their shares before the stock appreciates, the taxpayer paid taxes on income they never received.  

Conclusion

Ultimately, shareholders need to evaluate the advantages and disadvantages of this election with their tax advisor or professional and make a timely decision. Having corporate counsel at the outset of forming a company can prevent missing important deadlines. This issue matters for founders personally, but also for the startups they operate. Failure to timely file 83(b) elections by founders and early hires is a significant enough issue that subsequent investors will often conduct diligence into past elections to make sure this issue was handled competently in the early years of a corporation. Founders Law regularly advises founders and other stakeholders in filing their 83(b) elections and can help ensure you unlock the tax advantages of the election. 

Hind Abdelaziz is a startup and venture capital attorney based in Chicago, IL. She routinely represents founders, startups and venture capital funds in a wide variety of corporate transactions, including counseling clients on tax issues and navigating other matters associated with rapidly-growing startups. She can be reached at habdelaziz@founderslaw.com.