Of the countless details and decisions that the founder of a startup company is inevitably juggling as he launches his startup, one of the most important is making a timely Section 83(b) election. Under Section 83 of the Internal Revenue Code, an employee is not taxed on restricted stock received from an employer as compensation until the employee’s rights in the stock are either “transferable” or “not subject to a substantial risk of forfeiture”—that is, until the stock vests. While the advantage of this arrangement is that the employee does not have to report income at the time that he or she receives stock, the downside is that he has to report the full value of the stock (less any amount paid for it by the employee) as ordinary income at the time it vests. In the case of a successful startup, this value will likely have increased substantially from when the stock was initially received.
The solution to this problem is to make an election under Section 83(b). Under that provision, the recipient of the stock can elect to accelerate the taxable event by including in his or her taxable income the amount realized in the year in which he or she receives the stock. This amount is equal to the excess of the fair market value of the stock at the time of the initial transfer over the amount paid for the stock by the employee, a number that typically nets out at or close to zero. If the 83(b) election is made and income is recognized at the time of transfer, the compensation element of the transaction closes and the taxpayer is thereafter treated as the owner of the stock for tax purposes. Thus, in addition to saving the taxpayer from having to pay ordinary income tax on the appreciation of the stock’s value, any gain on a subsequent sale of the stock will be treated as capital gain provided that the employee has held the stock for at least twelve months.
One thing for investors to keep in mind is that if you snooze, you lose: an election under Section 83(b) must be made within thirty (30) days of receiving employer stock, and there are no exceptions for meeting this deadline. Thus, it is critical that a taxpayer considering a Section 83(b) election move promptly. Considerations for the employee of a startup with respect to this election might be how much tax would be owed if reported immediately, how great the likelihood of forfeiture is, and what sort of growth in the value of the stock can be reasonably projected.
There are other wrinkles and nuances, many of which are dealt with in extensive Treasury Regulations and other administrative guidance promulgated in connection with Section 83, so it is best to seek advice of tax counsel when considering the election.