The initial months of a startup can be a whirlwind for the founders – i.e., making final decisions regarding the team, picking the correct entity structure, agreeing upon the appropriate buy-sell terms, and leasing the right office space. 30 days can fly by in the blink of an eye. Depending upon the terms regarding the stock owned by the founders, the failure to make an election under Section 83(b) of the Internal Revenue Code (an “83(b) election”) during such 30 day period can lead to disastrous tax consequences for the founders.
Founders often purchase or are granted “restricted stock” in connection with forming their company, with the underlying restricted stock agreement providing that such stock is subject to forfeiture or repurchase by the company, with such stock becoming no longer subject to forfeiture or repurchase by the company over a period of years (often referred to as the “vesting” of restricted stock). Such restrictions are intended to prevent a founder that leaves the company after a short period of time from retaining some or all of his or her equity in the company.
Stock that is subject to vesting over time will generally be taxed when such stock is no longer subject to a substantial risk of forfeiture. Therefore, when the stock “vests,” the founder will be taxed on the difference, if any, between the fair market value of the stock as of the vesting date and the original purchase price for such stock. Every startup hopes that its stock rapidly increases in value, and in such scenario, a founder could have significant tax implications when his or her stock becomes vested.
That is where the 83(b) election comes in. If an 83(b) election is properly made, the founder will incur tax on all of the restricted stock in the calendar year when the stock is received. This allows the founder to incur and pay the tax when the value of the stock is low (or at least lower than when such stock will vest). The risk to the founder in making the election is that he or she ends up leaving the company (voluntarily or involuntarily) before the stock fully vests and loses all or a portion of his or her stock, but already paid the tax (if any) applicable to the receipt of all such stock.
In order to make a timely and effective 83(b) election, a founder must file the election with the IRS office with which the founder files his or her tax return prior to the date of receiving the stock or within 30 days thereafter. The election should be sent via certified mail, return receipt requested, and is effective upon mailing. Mailing an election on the 31st day after receiving such stock or thereafter will not be effective. A copy of the election should be attached to founder’s federal income tax return, and the founder should also provide the company with a copy. A sample election form may be found at the IRS website.