By Chase Addams, a San Francisco Business Attorney
You’re getting hired by a fledgling San Francisco Start-Up company, and you’ve just signed a Stock Purchase Agreement granting you a vesting equity interest in the Company. Congratulations and good luck. But watch out. Upon the initial grant of this stock to you, the clock starts running on your ability to make an 83(b) election under the Internal Revenue Code of 1986. You have 30 days from the date of grant. So what does that mean to you and what should you do?
At some point you have to report to the IRS (and get taxed for) the difference between the fair market value of the equity you’ve been given, and the price you paid for it (the “difference”). This reporting can either happen when you purchase the equity OR when your equity is actually freed of restrictions (ie, the Company’s repurchase right expires) and the shares vest to you. The difference is taxed as ordinary compensatory income. To be clear, in instances where equity is granted immediately and there is no vesting schedule, there is no decision to make and 83(b) does not apply. After vesting, when you’re ready to sell your equity or otherwise dispose of it pursuant to the terms of her Company Stock Purchase Agreement, the transaction will be taxed again as a capital gain.
The 83(b) election is a directive to the IRS to assess taxes on the difference at the time of stock purchase. While the fair market value at the time of stock purchase will oftentimes equal the amount paid, the IRS is free to evaluate the fair market value of the Startup Company shares for itself and decide differently.
The obvious advantage with being taxed on the difference at the outset instead of upon stock vesting is that the fair market value of the equity at the time of stock vesting (and therefore the taxes assessed) could be higher, even substantially higher, than at the time of purchase of your startup stock. The added benefit to election under 83(b) is that you will get the ball rolling on the time requirement to qualify as a long-term capital gain, which is taxed at a lower rate when you actually sell off your shares. On the other hand, those who do not elect under 83(b) don’t initiate the time period until after the ordinary income tax from the shares is recorded.
So the majority of the time it makes sense to elect under 83(b) for your startup stock purchase. There are instances where it’s advantageous to hold off on the election and tax the difference at the time of vesting, such as when the fair market value of the shares at the time of purchase is high and there is a possibility that the value will decrease over the period of vesting. Therefore, it is recommended that you consult a reputable, experienced CPA as soon as possible after purchase in order to decide if electing under Section 83(b) is the right decision.
Finally, on the flip side of the coin, for the actual San Francisco Startup itself, it is imperative that the corporation get the Purchaser to sign a waiver of the corporation’s responsibility in making the 83(b) election. Usually such waiver is contained within the Stock Purchase Agreement itself. It must be clear that the 83(b) election is a decision by the individual purchaser of the stock, NOT the Startup Corporation. The Startup should bear no liability in the individual’s decision.
If you have more questions about the 83(b) tax election or other business law matter please feel free to reach out to one of our Business Law Attorneys for a Free Consultation.