While most important business decisions center around the business itself, there’s a critical choice founders must make: whether to make a Section 83(b) election. If they don’t make the decision in time, founders could face some serious tax consequences.
What is a Section 83(b) election?
The Internal Revenue Service (IRS) spells out what an 83(b) election is in the federal tax code. This section of the code generally is applicable to company shares that are tied to a founder, investor, or any employee’s performance of services to a particular entity.
Here’s how it could play out for a startup:
You’ve received venture capital from an investor, who requires your founder stock in your company to vest. This means that, though you do own some shares, your access to them is limited at first. To earn them, you must meet some requirements. For example, you need to work at the company for a certain period of time or meet specific goals.
When it comes to paying your taxes, the IRS only considers the stock yours when it’s vested, you’ve met those requirements and it actually belongs to you. When founders make an 83(b) election, they signal their desire to be taxed on their shares of restricted stock when that equity is granted, not when it actually vests and is, presumably, worth more money.
Why choose an 83(b) election?
Simply put: To reduce your personal tax burden.
In the early days as they secure venture capital, founders often pay nothing – or next to nothing – for the shares in their company. It’s essentially a future payment for their sweat equity now.
If they did not choose an 83(b) election and those shares are vested, the IRS will require them to pay taxes based on the amount of money the vested shares are worth now minus what they paid for them originally. If the company has grown substantially over the course of a year or more and they didn’t pay anything for those shares, founders could face a larger tax burden.
If an 83(b) election was chosen and the shares eventually vest, that founder may owe nothing or very little to the IRS. Founders may still need to be mindful of capital gains, but their tax liabilities will be much less than if they had failed to make an 83(b) election.
When should I make an 83(b) election?
If an 83(b) election makes sense for your financial situation, don’t delay. You have just 30 days from the date that that you are granted the shares to file. And the IRS allows no latitude or leeway here. If you don’t file within those 30 days, you miss out. So, file the necessary paperwork as soon as you can.
How do I file an 83(b)?
If you’re working with an attorney, they can prepare this entirely for you and you just have to sign and mail it in. To make an election under 83(b), you send a letter by certified mail to the IRS office where you file your returns. Be sure to request a return receipt, which you should keep for your records, along with the letter you sent to the federal agency.
The letter must include several details, including your name, address, taxpayer identification number, a description of the shares related to the election, the date or dates when they will vest, the nature of the restrictions or requirements tied to the shares and the shares’ fair market value at the time of transfer. The letter also should include the amount, if any, paid for the shares.
Ultimately, you should speak to your accountant as you consider whether an 83(b) election is right for you so you can make the right choice for your own wallet and your future.. Keep in mind that this is a high-level look at a very complicated and confusing part of the federal tax code. A myriad of situations will determine whether it makes sense for you to take advantage of it.
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