The Section 83(b) election is a phrase that is bandied about quite often by startup founders and people involved with startups. But what is it exactly?
In its most basic form, this election can allow a startup founder who receives RSUs the ability to save a ton of money in taxes.
How so? Because in making a Section 83(b) election, you would essentially write a statement to the IRS notifying them that you wish to be taxed on the fair market value of the stock when it is granted to you, rather than the fair market value on the date it vests. You will need to make this election within 30 days after you are granted the restricted stock. If you do not make this election or do not make it on time, on the vesting date of the RSUs, the fair market value of the shares will be treated as compensation and taxed at regular income tax rates. Further, if you did not pay for the RSUs, and the value of the shares increases greatly between the grant date and vest date, then both the original value of the RSUs and the increase in the value will be treated as compensation on the vest date. If you paid nothing for the RSUs, and you filed a Section 83(b) election, then you would be taxed on the value of the RSU at the grant date.
As a startup employee, if you are granted RSUs, the amount of compensation will be reported on your Form W-2 for the year, and the company is required to withhold income and payroll tax. Companies who don’t do this, of course, are subject to substantial penalties related to under withholding.
Therefore, if you are a startup founder or employee, and you expect your RSUs to appreciate greatly (as would be the hope of any ambitious founder or employee), you would want to make a Section 83(b) election to be taxed at the time of the grant of the RSUs. In this scenario, any gain in the stock (assuming you held for longer than a year) would be taxed as a long-term capital gain and not at ordinary income tax rates, which means you would be pay a lot less in taxes in the future, since the long-term capital gains tax rate is lower than ordinary income tax rates.
You might ask, then, are there any scenarios under which I wouldn’t want to file a Section 83(b) election? Well, yes – if you expected the value of the stock to go down in the future, which, if you are an ambitious startup founder, would go against the very reason you founded the company in the first place, as no one starts a company with the intention of it failing. The other reason, though, would be if you were an employee and you received, say, 100,000 shares of company stock worth $1 per share, you would have an immediate tax hit. If you did not have a great deal of confidence that the stock would go up in the future, you might want to hedge your bets and save that money.
It bears mentioning again that failing to file a timely Section 83(b) election can be devastating in terms of personal taxation if your company does well and the price of the stock increases exponentially. Also, there are specific steps to take when filing this election, and you want to make sure you enlist a professional firm that has experience in such matters. If you are a startup founder or plan on being one, please get in touch with us today to discuss your options. A startup that is not founded correctly, especially from a tax perspective, may be doomed to headache and failure.