Generally speaking, founders or employees who receive stock (aka, equity compensation) from their company will have to recognize taxable income in one form or another. The total value of the stock and its corresponding tax is determined in part by the fair market value of the stock, but timing is everything. If your stock is not subject to vesting restrictions, you will owe taxes for the value of all shares based on the fair market value of the shares at the time of the grant --assuming you don't pay cash for your shares. If the stock is subject to vesting restrictions (which it should be), you should almost always file an 83(b) election to avoid paying higher taxes in the long run.
The Tax Owed on Almost Nothing is Almost Nothing
When stock is initially granted (which should be done right after the company is incorporated), the fair market value of the stock is usually negligible and the founder pays cash for it. When stock is granted subject to vesting restrictions, you will be taxed slowly and painfully over the entire vesting period (usually 4 years), UNLESS you file a timely 83(b) election.
By filing an 83(b) election, you can elect to be taxed on the difference between the fair market value of your stock when it is granted and the amount you pay for your stock. If you purchase stock when its value is low, the taxable income between the fair market value of the stock and the amount you pay for the stock will likely be negligible. In contrast, without filing an 83(b) election, you will have to recognize taxable income based on the difference between the amount you paid for your stock when granted and the fair market value of the stock as it vests. If the company is successful, the value of the stock---and the corresponding tax---could increase substantially over a 4 year vesting period.
Company Growth is Great, Until it Makes the Value of your Unvested Shares Skyrocket
Not yet convinced that failing to file your 83(b) could be an astronomical mistake? Here’s an example:
You join a new company and the company grants you 800,000 shares when the shares are worth $0.0001. You pay $80.00 for your shares, which is equal to the fair market value, but your shares are subject to a 4 year vesting schedule with a 1 year cliff.
If you file your 83(b) election on time, any increase in your stock’s value will not be recognized until the stock is sold, at which point, the increase in value will be taxed as capital gain as opposed to ordinary income. Check out what could happen if you don’t file your 83(b) election and the company grows year over year:
Year 0: Your shares are worth $80.00 [800,000 x $0.001 per share], and you paid $80.00 when you signed your stock purchase agreement, so you don’t recognize any taxable income.
Year 1: Company shares are now worth $0.20 per share. You vest the first 200,000 of your shares and recognize $39,980.00 in taxable income. [$0.2 x 200,000 - $20.00 = $39,980.00]
Year 2: Company shares are now worth $0.40. You vest another 200,000 shares and recognize $79,980.00 in taxable income. [$0.4 x 200,000 - $20.00 = $79,980.00] Hello new tax bracket!
Year 3: Company shares are now worth $0.80. You vest another 200,000 shares and recognize $159,980.00 in taxable income. [$0.8 x 200,000 - $20.00 = $159,980.00]
Year 4: Company shares are now worth $1.50. You vest the final 200,000 shares and recognize $299,980 in taxable income. [$1.50 x 200,000 - $20.00 = $299,980.00]
If you did file your 83(b) election, you recognize $0.00 of taxable income.
If you didn’t file your 83(b) election, you recognize $579,920 of taxable "income" over 4 years.
A note regarding capital gains taxes:
If you subsequently sell your stock, you will still have to pay taxes on the increase in value of the shares from the time you filed your 83(b) election (OR from the time the shares vested if you didn't file your 83(b) election). In order to take advantage of the lower capital gains tax rate, you have to hold the stock for at least a year before you sell. So, another benefit to the 83(b) election is that it allows you to trigger the holding period for the capital gains tax rate at the time of the initial grant.
If you filed your 83(b) election and want to sell as soon as the stock is fully vested, you will have met the holding requirement. If you do not file the 83(b) election and you want to sell as soon as it is fully vested, you will only be able to get the capital gains rate on the stock that vested a year or more before you sell. The portion of your stock that vested within the last year will not qualify for the capital gains rate. In other words, if you fail to file your 83(b) election, you will have to wait an extra year after your stock becomes fully vested before you can sell it all at once and get the capital gains tax rate for all of it.
Of course there is a flipside to electing to be taxed for all of your shares before all of your shares are vested. If you do file your 83(b) election, didn't pay cash for your shares, and don’t stay with the company until all of your shares are vested, you may have incurred taxes for shares that you never get if you leave or get fired. It’s almost always a good idea to file your 83(b) election, but everyone’s financial situation is different, so be sure to talk to your accountant first.
*This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.*