Start-Up Entrepreneur Series: 83(b) Elections

In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.  

The Start-Up Entrepreneur Series will be published each Wednesday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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Two weeks ago, we discussed considerations associated with the issuance of Company stock to Founders.  One of these considerations was the concept of “vesting”. To quote this very blog:

“Vesting” is a fancy legal term for a number of separate, but interrelated concepts related to giving back stock if a purchaser (or grantee) either leaves a relationship with the company (time-based vesting) or doesn’t do what they said they were going to do (milestone-based vesting).

In short, while a Founder receives stock (or “units of interest” in a limited liability company), the Founder is not secure in his or her ownership of that stock until it is “vested”.  Prior to that point, such stock may be forfeited (or repurchased at below market cost) by the Company.

Which raises the age-old question: What about taxes?

Or more specifically: “Should the recipient be required to pay taxes on the value of received stock immediately or only when the stock is “vested”?”.  After all, if the recipient eventually loses the stock, it doesn’t seem fair that they had to pay taxes on value that was never truly realized.

In Internal Revenue Code Section 83(a), the IRS agrees, stating that taxes on stock received by service providers will only be owed when the underlying stock is “vested” (or in their parlance, not “subject to a substantial risk of forfeiture“). At that time, the value of the stock over the amount paid for it will be deemed taxable.

Unfortunately, this reasonable stance (which is most easily read as attempting to benefit a recipient of “unvested” shares) can have significant, negative consequences.

The Issue – Growth

Consider the hypothetical high-growth start-up company.  Maybe it’s a software company on the cutting edge of VR.  Maybe it’s a brand new way to monitor brain surgery results. Whatever the case, the company starts out with nothing.  Nothing but the capital contributed by its founders, perhaps some equipment, and maybe a license (or bead on a license) for some important underlying technology.  By every reasonable approximation, the value of this type of company at its founding approaches zero.

Now imagine that same company 4 years ahead.  It maybe hasn’t set the world on fire, but it’s got a customer base, a viable product, and designs on the future.  It perhaps has even closed a venture (or other financing) round and thus has express written evidence of what a third party thinks the whole thing is worth.

Now consider what the IRS’s baseline taxation rule means in the case of a company founder initially issued unvested shares.  At the company’s founding, the value of those shares over the amount paid is effectively zero.  Without IRC 83(a), the founder would owe no (or almost no) taxes for the shares received.

Now imagine that the founder’s shares vest in their entirety on the fourth anniversary of his or her relationship with the company (this is simplified from the most common vesting schedules, but proves the issue here).  The founder (who was either granted or paid a nominal amount for his or her stock) would owe taxes on millions in value (depending on ownership percentage) when the vesting occurs.  Worse yet, all of that value would be “paper”.  The founder would have no liquid cash with which to pay the imposed taxes.

The founder would have been in a much better position had the IRS simply taken taxes from him or her at the outset.

The Solution – IRC 83(b)

Unlike some other nefarious potholes in the tax code, the IRS offers a solution to the “vesting” problem.

IRC 83(b) reads in pertinent part as follows:

Any person who performs services in connection with which property is transferred…may elect to include [the value] in his gross income for the taxable year in which such property is transferred…

An election under [this section] with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer.

So a Founder (or anyone else) can say to the IRS, “I appreciate your willingness to defer my tax obligations, but I’d just as soon pay taxes on this now, thank you very much.”

How is this election made?  The stock recipient must file a “Form 83(b)” with their local IRS office within 30 days of the applicable stock sale or grant.  I have included a sample Form 83(b) (using terms related to LLC interests) at the bottom of this post for reference.

(Note: The 30 day window here is very, very important.  If it is missed, it is often very difficult if not impossible to get the IRS to respect the election, and the recipient in question will be forced to deal with the tax situation if and when their stock “vests”.)

The form in question includes baseline identification information, a description of the nature of the “vesting” related to the issued equity, the amount paid for the stock received, and a determination of the fair market value of such same stock.  In addition to the initial filing, the Founder (or other recipient) must file a copy of such same form with their income return for the relevant year (i.e., by next April), and deliver a copy of the election to the stock issuer (i.e., the Company) for its own records.

On the question of a stock’s value, what is easy to answer at the formation of a company can become murkier and murkier as the Company begins and continues its operations. It is very difficult to value a close corporation or non-public LLC in the absence of third-party funding (which would set the price), and the recipient must certify their belief that the value is justified.  The Company and its stock recipients will need to communicate on these points if the recipient desires to make an 83(b) election.

Additional Considerations

As you can tell from the above, consideration of and conformance with the rules related to the submission (or lack of submission) of an 83(b) election is very, very important to minimizing the tax burden of Founders (and other Company employees).  As with any tax consideration, the financial status of the Founder in question, the nature and timing of likely Company growth, the type of the “vesting” at issue (recipients will want to be more cautious about making the election if there is a real chance that the stock received will never “vest”), and myriad other factors can all play into the decision.

While in almost all circumstances it will make sense for the Founders of a brand new start-up to make the election for all the reasons discussed in this post, there are exceptions to even that case. It always makes sense for Founders (and other individuals faced with these decisions) to consult with their own financial advisors and other tax professionals when determining the correct course of action.

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As always, if you have any insights on today’s post or would simply like to discuss further, please leave a comment down below or contact me at rhoeg@hoeglaw.com.  I’d love to hear your thoughts.

Form of 83(b)

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