This article provides a broad overview of Section 83 of the Internal Revenue Code and how it affects founders and employees who purchase stock that is subject to vesting. That is, stock that individuals gain rights to overtime. It also discusses who may want to make an 83(b) election and how they can do so.
Who should be concerned about Section 83 of the Internal Revenue Code?
Section 83 should be of particular concern to founders and employees who receive stock that is subject to vesting. Two examples are when a founder or an employee sign a restricted stock purchase agreement or if they agree to a stock option plan that allows them to exercise their options prior to vesting, but subject to a restrictive stock agreement. However, these are just two examples – you should consult your tax and legal counsel to determine whether your particular circumstances raise a potential Section 83 issue before signing a stock purchase agreement.
What is Section 83 and what happens if you do not file an 83(b) election?
Under Section 83, if you purchase stock that is subject to vesting and do not file an 83(b) election, you will pay income tax on the difference between the price paid for the stock and the stock’s fair market value when it vests, even if you do not sell the stock at that time. In addition, the holding period for determining whether the income from the sale of the shares qualify for long term capital gains treatment does not begin until the shares have vested.
How is the income from stock taxed if you make an 83(b) election?
In contrast, if you make an 83(b) election, the income from the stock is recognized at the time of the stock ”transfer” - its purchase date – rather than when the stock vests. The long term capital gains holding period also begins on the purchase date of the stock.
Why is it important when the income from your stock is recognized?
Often the purchase price and the fair market value of stock on its purchase date are the same. Thus, if you make an 83(b) election, you may not have any income to recognize from the stock purchase and may only have to pay capital gains tax when the stock is sold.
However, if you do not make an 83(b) election, you may have substantial income tax liability when the stock vests if the stock increases in value, even if you do not sell it.
You, therefore, may want to file an 83(b) election, particularly if you believe the stock is likely to increase in value. By doing so, the income from the stock will be recognized before it increases in value. As an added bonus, by filing the 83(b) you will also start the one year holding period for long term capital gains treatment from the date you purchase the shares.
What is an example of how stock subject to vesting is treated under Section 83?
You and a friend start a company and purchase stock at the par value of $.0001 per share that is subject to a one year cliff and a four year vesting period. Your friend promptly files an 83(b) election, but you forget to do so. At the end of the one year cliff the stock is worth $1.00 per share. Because you did not timely file an 83(b) election, you would recognize $0.99 per share as income, even if you do not sell the stock. As the remaining stock vests, you would also recognize income equal to the difference between the fair market value of the stock and the $.0001 per share price at which you purchased it.
In contrast, because your friend promptly made an 83(b) election, they would not recognize any income as the stock vests because the 83(b) election accelerated the recognition of the income from the stock transfer to the purchase date.
What are the drawbacks to making an 83(b) election?
If you do not pay fair market value for the stock and make an 83(b) election, you could possibly pay income tax on stock that does not provide you with any benefit.
For example, you join a company in June of 2011 that was started in May of 2010. You purchase 1,000 shares of restricted stock at the par value of $.0001 per share.
However, the company has been running for over a year and the fair market value of the shares is no longer par value, but is instead $1.00 per share.
If you file an 83(b) election, you would pay income tax on the difference between the fair market value of the stock and what you paid for your shares. In this example, you would pay income tax on $990.90.
If the company later dissolves and the stock is worthless, you would not receive any benefit from the income tax you paid. In addition, if you later forfeit the stock, perhaps by leaving the company, you will not be allowed a deduction for the income tax you paid on the stock at the time you made the 83(b) election.
However, if the purchase price and the fair market value of stock are the same and you make an 83(b) election, you would not have any income to recognize from the stock purchase and may only have to pay capital gains tax when the stock is sold.
How much time do you have to make an 83(b) election?
You must file an 83(b) election no later than 30 days after the stock has been transferred. The stock has been transferred on the purchase date of the stock, which is when you assume ownership of the stock. The postmark date is the date of the filing.
How do you make an 83(b) filing?
The 83(b) election must include:
- Your name, address, and tax identification number.
- A description of the property for which you are making the election. For example, “25 shares of common stock in X company.”
- The date on which the property was transferred and the tax year for which you are making the election.
- The nature of any restrictions on the stock. For example, “Stock must be forfeited if employment terminates before June 1, 2015.”
- The fair market value at the time of the transfer (ignoring restrictions except those that will never lapse) for which you are making the election.
- Any amount you paid for the stock.
- A statement that you have provided the required copies of the election, such as: “I have provided copies of this election as required in the regulation.”
The IRS does not provide a form 83(b) election, but you can find a sample 83(b) election form here. It is strongly recommended that if you decide to make an 83(b ) election, you send it via certified mail.
What else must you do to properly file an 83(b) election?
You should make two copies of the 83(b) election:
Attach a copy of the 83(b) election to your tax return for the year the stock was transferred; and
Provide a copy of the election to the company from which you received the stock.
If your employer transferred the stock to someone besides yourself, you must also provide a copy of the 83(b) election to that person as well.
Do you have any 83(b) tips or advice? If so, please provide them in the comments below.
If you have any questions regarding 83(b) elections or any other business legal issue, please contact me at Doug@BendLawOffice.com.
Disclaimer: This article is intended to provide information for your general education. It is not intended to be used and should not be used for the purpose of avoiding federal income tax penalties. Although the article discusses general legal and tax issues, it does not constitute legal advice. You should not act or refrain from acting on the basis of any information in this article. Instead you should seek the advice of tax or legal counsel who can discuss the facts and circumstances of your particular business or personal needs. Doug Bend expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.