Taxes as a founder can be confusing and overwhelming when you
are working on building your new startup. There are a lot of
questions surrounding filing taxes, and you want to make sure
you cover your bases to prevent any costly errors. Not only
that, but you likely want to only have to pay what you have to
and no more.
Understanding the tax code and what you need to provide is
essential to ensure you are able to save yourself from
overpaying on your taxes. When you have a complicated tax
situation as a founder with employees and equity compensation,
you can take advantage of the 83(b) election to minimize your
taxes. Learn everything you need to know about the 83(b)
Election and if you should or need to file one as a founder.
What is an 83(b) Election?
The 83(b) election is a way for both founders and employees of
startups to lower their tax burden. It's a short document you
send to the IRS to notify them that you would like to be taxed
at the current fair market value for your stock options or
grants when you receive them versus when they vest. It
essentially accelerates your income tax, where you prepay your
tax liability on a lower valuation with the hopes that the
equity value will increase.
When you sell your shares, you'll only be hit with the capital
gains tax versus the income tax, which can be much higher. The
longer you hold on to your shares after they vest, the fewer
capital gains tax you will have to pay.
How to File an 83(b) Election
Filing an 83(b) election is a simple process but does require you to be aware of timing. You must submit a letter to the IRS within 30 days of the approval of restricted stocks or option grants. The letter is intended to inform the IRS you are choosing to make an 83(b) election and want to be taxed. If you miss this deadline, your shares are taxed as ordinary income when the shares vest.
There is no formal form or paperwork to file an 83(b) election. You have to draft your own letter, which should include the following:
Personal identifying information such as your name, address, social security number
Description of the received grant or stock options, such as the number of units, the date received, and the current fair market value.
Any restrictions on the grant, such as termination clauses
How much was paid for the company shares, if applicable
A statement saying you have provided the appropriate parties with copies of your 83(b) election
The letter should be sent through certified mail with a return receipt to ensure the IRS receives the letter in a timely manner. A recent change allows for an 83(b) election to be signed digitally or electronically instead of handwritten signatures through October 31, 2023. A copy of the letter should be kept for each person electing, and any employees should provide their founders with a copy if they decide to go with an 83(b) election.
Who Can File an 83(b) Election
Filing an 83(b) election is available in a few situations to reduce your tax burden. Your employees or stock option holders can elect to file an 83(b) election within 30 days of the exercise of the stock options and minimize the tax liability for them if the share price rises over time.
For founders, compensation includes significant stock options or restricted stock units, which come with many rules they need to follow to benefit. The RSUs can allow you to save money in taxes by paying less in income taxes and only needing to pay capital gains.
When Should You File an 83(b) Election?
You should consider filing an 83(b) election under a few circumstances that should be weighed against the pros and cons. Filing an 83(b) election can be beneficial when:
You receive stock options with a low market value per share when you receive or accept the grant
You can afford to pay the taxes upfront if you opt-in
You believe the company's value will significantly increase over time
There is a small risk that you will forfeit the stock options such as you don't plan on leaving
You can sell the stock at a much higher price in the future
What Happens if You Don't File an 83(b) Election?
Founders, cofounders, and the company overall could potentially pay higher taxes and could face administrative burdens if the 83(b) election isn't filed on time or at all. Founders must determine the value of the shares during each vesting date to properly file taxes yearly to comply with tax withholding requirements and pay their share of associated employment taxes.
Because, as a founder, you would have to determine the value of the shares every year, you would also be responsible for paying taxes on the increased value of the shares. Covering the tax bill could be a challenge if there are any significant increases.
If you can file an 83(b) election on time, you can disregard the calculations for vesting periods for taxes. There will be less tax reporting or employment tax obligations.
Benefits of an 83(b) Election
Moving forward with an 83(b) election can save you significantly in taxes over time. If you decide to go with taxation at the time of the receiving of the grant or stock options, when the date of vesting arrives, if your stock value has risen, you will pay significantly fewer taxes. The 83(b) election is beneficial for people and founders who intend to be with the company in the long term, and you expect the value of the shares to rise over time.
Example of an 83(b) Election
If you start with shares of restricted stock that will vest over a select period of time, an 83(b) election could be a great option.
For example, let's say you receive 1,000 shares that are scheduled to vest over a period of four years, with 25% vesting each year. On the first vesting date, 250 shares will vest, 250 the next year, and so on. If you decided not to opt-in for an 83(b) election, once you choose to sell the shares after they vest each year, you will be taxed for a marginal tax rate and a capital gains tax rate.
Each share at this time is worth $1, and every year it increases by $1 with your base stock $1,000 worth. The first vesting shares (250) would be worth $500. In the second year, the vesting stocks (250) would be worth $750, the third (250) worth $1,000, and in the final year, the vesting stock (250) would be $1,250. Instead of paying taxes on the total earned over the 4 years, which is $3,500, you would only pay taxes on the worth in the first year or $1,000.
Common Risks of an 83(b) Election
While an 83(b) election can be beneficial, some risks should be considered before you decide whether or not to pursue it. Some of the things to consider include:
Cash Up Front – With an 83(b) election, you want to ensure you have enough cash on hand to pay the taxes upfront while accelerating the exercise of stock options. If you choose not to file an 83(b) election, you will have more cash available to cover the tax liability when the shares vest.
Risk of Forfeiture – Submitting an 83(b) election is allowed only if there is a risk of forfeiture. If the startup fails or employees leave before the vesting date, or if performance milestones are not reached, you may have to forfeit the shares or options. This would mean you paid taxes on the compensation you never received.
Tax Rate Changes – There could potentially be updates to the tax code, which could change the income rates versus capital gains rates. If the difference is higher tax rates, the benefits of an 83(b) election are no longer viable at the time of vesting.
No Price Appreciation – Making an 83(b) election makes the most sense if the stock appreciates over the vesting schedule; however, it's hard to predict the price. If the price drops or the company fails, you end up paying more taxes than necessary.
Making an 83(b) election has a lot of benefits to offer founders and employees alike. It's a decision that should be made carefully as you consider the risks, benefits, and your startup's situation. If your startup is in a great position to grow and earn a significant amount, you and your employees with stock options could save significantly in your tax burden, allowing you to keep more money in your pocket as your startup grows.
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