Successful founders that fail to affirmatively make a Section 83(b) election may face staggering tax consequences years down the road.
The Internal Revenue Code (the “Code”) generally requires founders (or employees) that are granted restricted stock for services to report income as the stock vests. Accordingly, any increase in stock value beyond the purchase price is recognized at vesting, regardless of sale, and taxed at ordinary rates.
Section 83(b) of the Code, however, allows founders (or employees) to affirmatively elect to be taxed on the value of restricted stock at grant rather than vesting. Because the purchase price of stock at grant is often equivalent to its fair market value, an 83(b) election typically results in zero recognizable income. What is more, the election advances the beginning of the one-year capital gain holding period, often resulting in preferential capital gain rather than ordinary tax treatment upon sale. For an 83(b) election to be effective, it must be filed with the IRS within 30 days of the purchase date.
The 83(b) election is not without risk, however. If the stock does not increase in value after grant, an 83(b) election needlessly accelerates tax payments without any corresponding benefit. Worse, stock forfeiture after grant may result in paying tax on unrealized income.
All things considered, an 83(b) election will likely be advantageous if: (1) the amount of income reported at grant is small; (2) the stock’s growth prospects are moderate to strong; and (3) the risk of stock forfeiture is very low.
To the contrary, an 83(b) election should be avoided where there is: (1) a moderate to high risk of stock forfeiture; or (2) a heavy tax burden at grant coupled with low to moderate growth prospects. As always, consult with your tax advisor to determine how a Section 83(b) election applies to your individual circumstances.