Strategic Tax Planning for Startups: Understanding the Section 83(b) Election

By:  Tony Mauriello, Esq.

In the entrepreneurial ecosystem of Silicon Valley, particularly within the dynamic landscape of startup companies, equity compensation plays a pivotal role in attracting and retaining top talent.  However, the draw of equity comes with complex tax implications that can significantly affect both the recipient’s financial outcome and the startup’s equity structure. One of the critical decisions facing founders and early employees in a startup involves making a Section 83(b) election—a choice that can have profound tax consequences.

Quick Primer on Taxes

The tax landscape in the U.S. features a bifurcated system where ordinary income is taxed at a higher rate compared to long-term capital gains. As of 2024, the maximum ordinary income tax rate stands at 37%, contrasting with the maximum long-term capital gains rate of 20%. For startup employees, who often receive equity at a nominal value that could appreciate significantly, electing to be taxed at the grant date under Section 83(b) of the Internal Revenue Code (IRC) could lead to considerable tax savings by converting more future gain into the lower-taxed capital gains category.

Under the U.S. tax code, specifically Section 83 of the IRC, when someone receives property (in this case, stock) that is subject to certain conditions (such as vesting), the IRS usually taxes this property as ordinary income when the conditions are met or no longer apply. However, by filing an 83(b) election within 30 days of receiving such property, individuals opt to incur tax immediately based on the property’s fair market value at the time of grant.

What is an 83(b) Election

A Section 83(b) election is a formal notice sent to the IRS, allowing individuals who receive restricted stock to be taxed on the value of their equity at the time of the grant instead of when the equity vests. This preemptive move accelerates the taxation event to the grant date, potentially locking in a lower tax basis and aligning tax liabilities with the actual receipt of equity (upon its vesting).

The primary rationale behind filing an 83(b) election lies in the potential for significant tax savings. This strategy is particularly effective in startup environments where equity values can appreciate rapidly. By choosing to be taxed at the grant date, individuals may pay taxes on a lower value, before any potential appreciation, thus reducing their overall tax liability when compared to being taxed at vesting, at which point the value of the stock may be substantially higher.

Moreover, filing an 83(b) election starts the clock on the holding period for capital gains treatment earlier. This means that, should the stock appreciate in value, more of the gain will be eligible for the more favorable long-term capital gains tax rates, provided the stock is held for over a year from the grant date (and not just from the vesting date).

Risks and Considerations

Despite its potential benefits, an 83(b) election is not without risks. If the value of the stock decreases after the election, the taxpayer cannot reclaim the taxes paid on the higher initial value. Furthermore, if the stock is forfeited (e.g., if the employee leaves the company before vesting), the taxpayer cannot recover the taxes paid upon filing the election. This makes the decision to file an 83(b) election a calculated risk, requiring careful consideration of the company’s potential and the likelihood of an increase in the value of the stock.

Taxation Examples: With and Without Section 83(b) Election

To more clearly illustrate the potential financial implications of an 83(b) election, consider an example in which the CEO/founder of Widgets R Us, Inc. is granted 50,000 shares of restricted stock with a grant price of $0.05 per share. Let’s assume the value of the stock increases to $2.00 per share at the time of vesting and eventually reaches $10.00 per share when sold more than one year after the grant date. For simplicity, we will again assume the founder is subject to the maximum ordinary income tax rate of 37% and the long-term capital gains rate of 20%.

Without an 83(b) Election

  • At Vesting: The founder does not make an 83(b) election and therefore incurs no tax liability at the grant date. Upon vesting, the value of the shares has increased to $2.00 per share. The taxable income is calculated based on this value, resulting in a taxable amount of $100,000 (50,000 shares x $2.00 each). The tax due at the ordinary income rate of 37% would be $37,000.
  • At Sale: When the shares are sold more than one year after vesting for $10.00 per share, the sale price is $500,000 (50,000 shares x $10.00 each). Since the cost basis is $2.00 per share, the taxable gain is $400,000. The long-term capital gains tax on this amount, at a rate of 20%, would be $80,000.
  • Net Proceeds: The net gain after taxes would be $500,000 (sale proceeds) – $37,000 (tax on vesting) – $80,000 (capital gains tax) = $383,000.

With an 83(b) Election

  • At Grant: The founder timely files an 83(b) election within 30 days of the grant, opting to be taxed immediately on the shares at their grant price of $0.05 per share. The total taxable amount is $2,500 (50,000 shares x $0.05 each). The tax due at the ordinary income rate of 37% would be $925.
  • At Sale: The shares are later sold for $10.00 per share, totaling $500,000. Because the founder elected to be taxed at the grant price, the entire gain of $9.95 per share ($10.00 sale price minus the $0.05 grant price) is considered for capital gains. The taxable gain is thus $497,500, and the long-term capital gains tax on this, at a rate of 20%, amounts to $99,500.
  • Net Proceeds: The net gain after taxes would be $500,000 (sale proceeds) – $925 (tax on grant) – $99,500 (capital gains tax) = $399,575.

Navigating the Decision

Making an 83(b) election requires a forward-looking analysis of the stock’s potential value, the individual’s tax situation, and the likelihood of vesting. Additionally, the decision to make such an election must be made (and filed) within 30 days of receipt of the stock. While the election can offer substantial tax savings and more favorable tax treatment of future gains, it is not without risks, including the potential for overpayment on stock that never vests or decreases in value. Therefore, this decision should be approached with careful consideration and, ideally, in consultation with a corporate attorney familiar with the intricacies of equity compensation taxation.

Tony Mauriello is a corporate attorney in San Diego specializing in mergers and acquisitions and tech transactions who works closely with both public and privately-held companies.

 

This blog is written as of March 2024.  Recommendations and legal requirements are changing rapidly, so please continue to review our legal updates or review postings on relevant government websites.

All blogs on this site are for educational purposes only, do not constitute legal advice or opinion, and should not be applied to your situation, or any specific situation, without consultation with counsel. Strategy Law, LLP does not provide any legal advice concerning any matter discussed in a blog except upon formal engagement including, without limitation, execution of Strategy Law, LLP’s formal legal services agreement, and with respect to specific factual situations.  No blog constitutes a guaranty, warranty, or prediction regarding the result of any legal matter discussed in the blog or any representation.

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