What’s an 83(b) election, and when is it a good thing to do?
Great question, and one every entrepreneur, founder, contractor, or anyone else trading work for equity should know the answer to. In this two-part post, I’ll first explain what the 83(b) election is, then I’ll walk through a situation where making the election makes good sense, and in the second installment I’ll walk through a situation in which making the election wouldn’t make sense (and some other considerations that might prevent you from making it). And with that, off we go.
As a basic starting point, when you’re given equity in a company as compensation you have to pay taxes on it the same way you have to pay taxes on any other income. When it comes to how much you pay, the IRS is going to calculate your tax liability based upon the fair market value of the equity at the time it’s transferred to you. When it comes to when you’ll pay those taxes, the IRS is going to require you to pay tax on the income during that year in which the equity is actually transferred to you such that you could do what you want with it.
Very frequently though, especially with founders, any grant of equity is going to be subject to a vesting agreement. What that means is that under the default rule, you don’t pay taxes on any stock until it actually vests, and you pay taxes based upon the value of the stock at the time of vesting. As a practical matter, what this means is that if the company does really well and goes up in value over the course of the vesting agreement, you’re going to end up paying more and more taxes over the years.
The IRS has implemented another option, though, the 83(b) election. Codified at 26 U.S.C. § 83(b), this election lets you decide at the start of your vesting agreement to be taxed for the entire amount that will eventually vest at the present value. Rather than paying tax each year then, you pay all the tax up front based on the value of the stock when it was granted to you. In order to make this election, you have to send a letter to the IRS within 30 days of the grant being made. The IRS has published a sample letter that outlines all the information needed.
This can all get a little confusing, so when does it make sense to take this election, when will it save you tax money? Well, one situation where it usually makes a lot of sense to take the election is where you’re a founder of a brand new company with no real value, and you’ve agreed to a multi-year vesting agreement. In such a situation, you pay tax up front on all the shares when they’re valued basically at nothing. You only pay tax again when there’s some kind of liquidation event. As long as that event comes more than a year after the grant, you’ll end up paying taxes at the long-term capital gains rate, which is a lot lower than the typical income tax rate, and you come out way ahead.
To spell this out a little more clearly, I’ve put together a graphic outlining the tax liability that you’d encounter in this situation, under both the default rules and with the 83(b) election. For the purpose of the graphic, assume:
- Brand new company with two founders;
- Each founder is granted 1,000 shares on a two year vesting plan;
- Price per share at founding is $0.01;
- Income tax rate of 33%, long-term capital gains rate of 20%.
So here it is:
As you can see, the difference in ultimate tax liability, and in what you have to pay each year (especially if you haven’t actually been paid any real money yet) can be huge in a situation like this and so it’s crucial to understand what the 83(b) election is and make sure you get it done.
Check out Part 2, in which I go through a scenario where the 83(b) election doesn’t make sense.