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83(b) Election

Founder Shares and the 83(b) Election

Startup founders typically receive shares in the new company. Because launching a new entity takes a bit of grunt work, shares normally vest on a specific schedule. Some shareholders may use Section 83(b) of the tax code as a way to manage tax burden for shares that may experience a rapid rise in value.

 

How Do Startup Shares Vest?

If shares are vested, holders get ownership on a proportional basis over a set schedule. As an example, a founder with a 10 percent stake may get 2.5 percent vested after the first year, then a proportional amount until the entirety of the 10 percent is vested by the end of four years. If she leaves after three years, she retains 7.5 percent and forfeits the other 2.5 percent.

 

What Happens With an 83(b) Election?

By default, the Internal Revenue Service taxes shares at an ordinary income tax rate when they vest. Under 83(b), shareholders can elect to pay tax on shares as soon as they are granted. When shares are sold, the taxpayer pays capital gains tax on the difference between the value at sale and when the shares were first declared as income.
Assume you have 1,000 shares, worth $0.01 at the time you receive them, $5 at the time of vesting and $50 at the time of sale. Also assume an income tax rate of 39.6 percent and a capital gains rate of 20 percent.

 

With no 83(b) election:

Pay no income tax at the time of grant.
Pay $1,980 in ordinary income tax when shares vest ($5 x 1,000 x 39.6%)
Pay $9,000 in capital gains tax at time of sale (($50 – $5) x 1,000 x 20%)
Total amount made on sale: $39,020 ($50,000 – $1,980 – $9,000)

 

With 83(b) election:

Pay $3.96 in ordinary income tax at time of grant ($0.01 x 1,000 x 39.6%)
Pay $0 in ordinary income tax when shares vest because of 83(b) election
Pay $9,998 in capital gains tax at time of sale ($49.99 x 1,000 x 20%)
Total amount made on sale: $39,998.04 ($50,000 – $3.96 – $9,998)
Tax savings with 83(b) election: $978.04 ($39,998.04 – $39,020)

 

What Are the Risks?

Electing to pay tax under 83(b) assumes the value of shares will rise. If the company declares bankruptcy and shares become worthless, a shareholder may have paid more tax than under the default scheme. Also, if she leaves the company before the shares are vested, she pays income on more shares than she ultimately receives. You should choose quickly: the IRS only gives taxpayers 30 days from granting of shares to elect under 83(b).
Johnstun Law can help you with all your Utah business legal needs. Contact us today to get started.