How to File an 83(b) Election
Founders of startups typically purchase stock in their startup pursuant to a restricted stock purchase agreement, or RSPA. The “restricted” portion of the stock purchase agreement refers to a vesting schedule that gives the company the right to repurchase any unvested stock upon their separation from the company. As various time milestones are met in the RSPA, the stock “vests” or is released from the repurchase option. While the purchase price of the stock is paid at the beginning, the founder doesn’t acquire all the rights associated with the stock, such as the right to sell the stock, until it vests. To the IRS, this means that the stock is acquired when released from the restrictions, which kicks in tax considerations.
When purchasing stock generally, a founder won’t be liable for income tax on the purchase if the price paid for the stock was equal to the fair market value, or FMV.
Recall, however, that for a typical startup, the founder is purchasing restricted stock, which means that they don’t get all the rights associated with the stock at the time of purchase. This triggers looking at the price of the stock when the stock becomes fully vested which can be years later and a substantially higher FMV. This in turn could mean a substantial tax bill for the founder, as well as an obligation by the company to withhold taxes as each tranche of stock vests.
Under 26 U.S.C. § 83(b), the founder may elect to have the IRS look at the price of the stock at the time of purchase and not at the time that the stock is fully released from restrictions (the company’s right to repurchase).
If the purchase price of the stock is equal to the FMV, which is typically very, very low at the outset, then there is no tax liability. In order to take advantage of this, however, the founder must notify the IRS that it is choosing to take advantage of section 83(b). This is done using an 83(b) election. This 83(b) election must be filed with the IRS no later than 30 days after the date of purchase. The 30-day clock starts to run on the day after the date of purchase. The election must be postmarked within this 30-day period. The 30-days are absolute calendar days, not business days. This means, weekends and holidays count as part of this 30-day period. There are no exceptions or extensions to the 30-day period. If you miss it, too bad, so sad for you.
Let’s look at an example.
Jack and his friend, Jane, decide to found a new internet startup. Per conventional wisdom, they decide to purchase their ownership rights in the startup company using a RSPA containing a four year vesting schedule with a one year cliff. They each purchase 4 million shares of the company’s common stock at $0.001 per share for a total purchase price of $4,000 each. They pay their $4K on January 1. On January 2, the clock starts. They have until January 31 to get to the post office and get the election postmarked.
Mail the election via certified mail to the IRS Service Center where you would normally file your personal tax return.
This is an added level of precaution since you don’t want your election to get lost in transit and blow your 30-day time period. Using an overnight or second day carrier is also a good idea. The last step in the process then is to make sure that you maintain a copy of the election with the company’s corporate records AND include the election with your year end tax return. This last item is critical; the IRS does not actually verify that an 83(b) election was timely filed until the individual making the election sends in their personal income tax return. So, whether you snail mail your tax return to the IRS (who does that anymore???) or use tax software like Turbotax, you want to make sure to include a copy of the election.
Failing to file an 83(b) election can have really, really bad consequences.
For one, an investor may back out of making an investment because the founders failed to file 83(b) elections. So, of all the things to not stay on top of, this isn’t one of them. Make sure to keep an eye on the calendar and get help if you aren’t sure what to do to make an 83(b) election.