By Ed Zimmerman & Lesley Adamo
February [ ], 2020
Zimmerman Chairs the Tech Group at Lowenstein Sandler LLP & is an Adjunct Professor of Venture Capital at Columbia Business School. Adamo is a partner in Lowenstein Sandler’s Tax Department. They work together on venture capital, growth equity and M&A transactions.
Now, Jack, he is a banker,
And Jane, she is a clerk.
And the both of them save their money…
Then they come home from work”
-Lou Reed, The Velvet Underground
Founders of startups usually hold their stock subject to “vesting” (stock subject to vesting is also known as “restricted stock”), which generally raises a tax question under Section 83(b).1 How the founder answers this tax question – and they must answer it early in their vesting period – could tremendously impact that founder’s taxes, both now and in the future, on that stock.
This article (1) discusses the general tax treatment of receiving ‘restricted stock’ (stock subject to vesting) whether for a founder, executive, board member, advisor or anyone else providing a service to the company, (2) considers the commonly discussed election under Section 83(b) (an “83(b) Election”) as well as the interplay between Section 83 and Qualified Small Business Stock (or QSBS), and (3) lays out detailed examples of how (not) making a Section 83(b) Election could play out over the several years following receipt of restricted stock. For more on QSBS, see Edward Zimmerman and Brian Silikovitz, “Gimme Shelter: VC-Backed M&A Tax Strategies For QSBS/1202,” Forbes (July 18, 2016, we refer to this article as the “Zimmerman/Silikovitz QSBS Article”).
Ed Zimmerman and Lou Reed
Vesting Triggers Complex Tax Consequences.
Anyone who receives stock subject to vesting in exchange for performing services is potentially subject to special tax rules (the special income inclusion rules of Section 83). So even though this article is aimed at founders, board members, and senior executives at startups and growth companies, this article and these rules apply more broadly, as Section 83 would apply to executives, board members, advisors and other key employees who receive restricted stock (including in the public company context).
Section 83’s general rule appears in Section 83(a), which provides that when a service provider (i.e., an executive or board member) receives stock (or other property) for rendering services and that stock is vested (there’s no substantial risk of forfeiture or the stock is transferable), the service provider has taxable income equal to the fair market value of that stock. The underlying policy is simple: whether you compensate an executive (for instance) with stock, cash or other “property” (a new car, etc.), the IRS treats that as income and values it the way the market would.
Where Section 83 gets interesting, however, is in the timing of both (1) when the service provider (or executive) must take that stock into income and (2) when the stock taken into income must be valued.
The executive or other service provider receiving stock in exchange for services, must include in income the fair market value of the stock received on the date the stock is first either transferable or not subject to a substantial risk of forfeiture. In other words, if there’s no vesting conditions on the stock, the executive is taxed when receiving the stock at the then-fair-market-value of that stock. But what about when the stock is subject to vesting?
When a founder, executive, board member, advisor or other service provider receives nonvested stock – stock that is both subject to a substantial risk of forfeiture and not transferable – that stock is taken into income ONLY when the stock vests. The taxpayer must include the stock in income at the stock’s fair market value at the time of vesting. Here’s why this is so significant: if a founder receives 40% of the company for $100, but agrees to a customary four (4) year vesting and the startup becomes valuable, the founder will incur a potentially massive income tax liability as the shares vest and increase in value over that time.
Enter Section 83(b) to shake things up!
Section 83(b) provides a way for the service provider (founder/executive, etc.) to include that stock in income right away at that stock’s then-current (hopefully lower) fair market value – you do this by making an 83(b) Election. This can save founders and other service providers a massive amount of income tax, but the rules are complicated and very specific.
As a lawyer representing startups, growth companies and venture funds2 and a tax lawyer dealing with those same clients, we have walked countless founders, executives, board members, and other service providers and companies through the tax implications of receiving/granting restricted stock and of making 83(b) Elections. Because we represent those same clients in buying and selling those companies years later, we also have the benefit of hindsight, which informs us about the issues that often arise in a sale process when we look back at restricted stock issuances and the related decision to make/not make 83(b) Elections (as well as the relevant corporate records).
It is important to note that the elements that make section 83(b) of the tax code apply are (1) the company is granting stock not stock options (more on that below), (2) the recipient is providing a service to the company, and (3) the shares are subject to vesting, which may be time-based (the most common vesting trigger we see in the startup/growth company market) but may also be based on, for instance, the company increasing total earnings. When those three elements apply, whether the recipient has paid something (ranging from close to nothing all the way up to fair market value or even above) or nothing for the shares, we must look to section 83(b) of the tax code. For more on vesting based on things other than purely time-based vesting and on the definition of “substantial risk of forfeiture” more generally, please see the section below entitled “Are 83(b) Elections Only Relevant When Stock is Subject to Time-Based Vesting?” and for more on other property that is subject to Section 83, please see the section below entitled “Do Stock Options, LLC Interests, and RSUs Trigger 83(b)?”
For convenience, we refer to the recipient as a ‘founder’ throughout this article, though it could easily be an executive, employee, board member, advisor or other provider of services who gets stock subject to risk of forfeiture in connection with rendering services.
Section 83(b) & Starting the Clock on Long-Term Capital Gain and QSBS
In relevant part, Section 83(b) provides that:
transferred, the excess of—
to any restriction other than a restriction which by its terms will never lapse), over
(B) the amount (if any) paid for such property.”
The upshot is that if you provide services to a corporation, receive stock from that corporation and agree to vesting on that stock, you should consider whether you can and should make an 83(b) Election. When you make the 83(b) Election you are telling the IRS that you are taking the stock into income at the fair market value on the date you received the stock, rather than recognizing income (and incurring tax liability) when the shares vest. Making the 83(b) Election also means that (for capital gains and, if eligible, for QSBS), you are starting the clock when you received the shares rather than over time as the shares vest. For more on QSBS see the Zimmerman/Silikovitz QSBS Article. It’s important to also understand that without a timely filed 83(b) Election, the clock on long-term capital gain only begins when the shares vest – so if there are multiple vesting dates, you will have multiple clocks to monitor for long-term capital gain – and, if eligible, QSBS. The law itself3 provides:
“(a) Holding period. Under section 83(f), the holding period of transferred property to
which section 83(a) applies shall begin just after such property is substantially vested.
However, if the person who has performed the services in connection with which property is
transferred has made an election under section 83(b), the holding period of such property shall
begin just after the date such property is transferred.”
In other words: the date you take the stock into income (by either timely filing the 83(b) Election or by vesting because restrictions have lapsed) is when the clock on capital gain (and QSBS) starts. In order to treat capital gain as long-term, you must hold the stock (or other assets) for more than one year before selling. Stock (or other assets) held for less than that are taxed as short-term capital gain (which the IRS treats as ordinary income4).
By making the 83(b) Election and starting the clock at receipt of the shares, you increase the likelihood that when you sell your shares you can treat the gain as long-term gain. For instance, if you made an 83(b) Election on stock you received (subject to four-year vesting) on January 8, 2019 and therefore took it all into income in January 2019, after January 8, 2020, the sale of every one of those shares would be treated as long-term capital gain. In contrast, without that 83(b) Election, those same facts would preclude treating any of those shares as eligible for long-term gain when sold on January 9, 2020 and, instead, you would have income as the first tranche of those shares would just be vesting. You would have been tax-disadvantaged because the long-term capital gain clock would be just starting on that first tranche (with the remainder of the shares to continue vesting over time). This matters greatly because of the “spread” between long-term capital gain and ordinary income under U.S. tax law.
Being on the Right Side of the “Spread” (Long-Term Capital Gain vs Income)
Currently, the highest marginal tax rate on ordinary income at the U.S. federal level is 37%, while the U.S. federal long-term capital gain rate starts at 0%, goes to 15% and then caps at 20% of the gain. Accordingly, taxpayers in the highest tax bracket owe the IRS ¢17 more out of every $1 they receive if they have ordinary income (or short-term capital gain, which the IRS treats as ordinary income) rather than long-term capital gain. In other words, a taxpayer who could have paid long-term capital gain rates but instead pays ordinary income rates has overpaid by 85% (37% is 185% of 20%) or has suffered a 17% “spread” between the ordinary income rate and the long-term capital gain rate. Either way, the benefits of starting the clock for capital gain are self-evident: you may be able to meaningfully shrink your tax burden when you sell.
QSBS vs. Everything Else: Being on the Super Duper Right Side of the “Spread”
Think of QSBS as the government’s granting of super-charged benefits to taxpayers who hold stock in startups for a really long time. QSBS benefits can apply when you sell eligible stock that you have held for more than five (5) years. The rules are complicated but the seller (a founder, a venture fund, an angel investor, an executive, a board member, etc.) can exclude from gain the greater of $10 million or 10 times the holder’s cost basis in that stock. So a founder who bought stock for $500 and, more than five years later receives $10,000,500 at exit, pays no capital gain tax federally at exit if the shares are good QSBS. Similarly, if we change the facts so that the seller is a venture fund that had invested $6 million in good QSBS, the first $66 million of proceeds from selling that stock after five years (without a disqualifying redemption) may well be received without an obligation to pay a penny in long-term capital gain tax at the federal level. If this sounds too good to be true, have no fear: there are complicated rules and limitations, however, we do see good sales of QSBS with some regularity. If you are a potentially qualified holder of restricted stock that may be eligible for QSBS treatment, it may make sense for you to accelerate the start of the QSBS (and long-term capital gain) holding period by making an 83(b) Election. We fleshed out the QSBS rules in greater detail in the Zimmerman/Silikovitz QSBS Article.
Vesting Can Trigger “Phantom Income”
Where a founder receives restricted stock in exchange for services, the founder will have taxable income, either from making the 83(b) Election or, absent making an 83(b) Election, if, as and when the restrictions lapse.
For instance, a startup with two founders, each subject to vesting has one founder who makes an 83(b) Election and another who does not. Each receives 100 shares, subject to customary four-year vesting where the first 25% vests on the one-year anniversary of employment and thereafter in 36 equal amounts monthly. The founder who files the 83(b) Election recognizes income at the fair market value of those shares as of the date of receiving those shares. The founder who does not file (either because that founder chose not to file or failed to timely file) will recognize income at each vesting date at the fair market value of the stock that vests as of the date of vesting.
Both founders will have “phantom income,” meaning that they have taxable income even though they have not received cash. The founder who made the 83(b) Election will have one phantom income inclusion with respect to all of the shares (at the time of receiving those shares) and the founder who did not will have multiple phantom income inclusions spread out over time. However, depending on the value of the shares on vesting, overall the founder who failed to make the 83(b) Election may have a much greater phantom income inclusion, and therefore, a far more massive income tax burden than the founder who made the 83(b) Election.
30 Days: When Must I File my 83(b) Election?
Measuring from the date you received the stock, the IRS allows 30 days – and not a minute longer – to make the 83(b) Election. As the law itself provides:
days after the date of such transfer. Such election may not be revoked except with the consent
of the Secretary.”7
There is no exception to that 30 day rule (even if the dog ate your homework), except that “[i]n accordance with § 7503, if the thirtieth day following the transfer of property falls on a Saturday, Sunday or legal holiday, the election will be considered timely filed if it is postmarked by the next business day.”8 Because of this strict deadline for making the election, if you know you may receive restricted stock (or if you have received restricted stock), you should immediately seek tax advice. In the words of the late Neal Peart, “If you choose not to decide, you still have made a choice” because hesitating beyond that 30 day mark is a decision to forego the opportunity to make a timely election.
When you make the 83(b) Election, you recognize ordinary income for the taxable year in which you received the shares in an amount equal to the difference between the fair market value of those shares on the date of receipt and what you paid for those shares. So, if you pay $10 for the shares and the fair market value at the time you received the shares was $10,000, you will have $9,990 of income at that time and the company will have employment tax withholding and W-2 reporting obligations if you are an employee or a Form 1099 reporting obligation if you are a contractor/consultant.
Example of How the Math Works for Making/Not Making the 83(b) Election:
Here is a pretty detailed example to illustrate how this works. The value of the stock at the times of receipt, vesting and exit will dramatically shift the amount saved, so this is intended to share some math specifics on paper, as it can be hard to walk clients through this math by phone when they are deciding whether to make an 83(b) Election.
Example (1): On June 2, 2014, Startup grants 1,000 shares of its common stock to its co-founder, Jane, in connection with Jane rendering services as an executive. There’s a roughly contemporaneous valuation report for purposes of Section 409A (see below regarding the relevance of Section 409A to Section 83) saying that on that date (June 2, 2014), the shares are each worth $10 or, in aggregate, $10,000. Jane paid $0.01 per share (or $10) for all of her shares, even though fair market value was $10,000. At the time of grant, she agrees that her shares will be nontransferable and will vest in four tranches (25% each) each year (so four years vesting total). On June 28, 2014 Jane properly and timely files her 83(b) Election, return receipt requested, and retains a copy for herself, forwarding another copy to Startup, which it dutifully keeps on file. On her 83(b) Election, Jane reports $10,000 as the fair market value of the stock transferred and $10 as the amount paid for the stock and when it is time to file her tax returns for tax year 2014, Jane pays income tax on the $9,990 difference, while Startup includes it in her W-2 and does the appropriate withholding as if it had bonused Jane $9,990 in cash.
Assumptions: Jane’s effective federal tax rates are 37% on ordinary income/short-term capital gain and 20% on long-term capital gain. For purposes of simplifying this already complicated example, we are omitting other taxes (state and local taxes, employee or employer withholding taxes, etc.).
Result for Example (1): Jane pays $3,696.30 of federal income tax on the shares for 2014 if she makes the 83(b) Election. If Jane does not make the 83(b) Election, she pays more than 10 times that amount ($40,696.30) in federal income taxes (for those same shares) over the subsequent four years and delays starting the clock for long-term capital gains and QSBS. Here’s how that works.
IF JANE FILES HER 83(b) ELECTION: If Jane properly and timely files her 83(b) Election, then in 2014 she has an ordinary income inclusion of $9,990, which is the result of $10,000 of stock less her $10 cost, resulting in $3,696.30 of tax. Jane begins both the capital gains and QSBS clocks on June 2, 2014. If Jane’s stock appreciates, she will have good long-term capital gain treatment for any and all of her shares after June 2, 2015. Moreover (assuming no disqualifying events and that Startup and Jane are eligible for QSBS – see the Zimmerman/Silikovitz QSBS Article), Jane has good QSBS starting after June 2, 2019, and can have even more favorable tax treatment than she would have if solely long-term capital gains rates applied.
IF JANE DOES NOT TIMELY/VALIDLY FILE HER 83(b) ELECTION: In contrast, if Jane does not timely and validly file an accurate 83(b) Election, she includes those shares in income as they vest (meaning on each vesting date) at the fair market value of those newly-vested shares as of the dates on which those shares vest. This can be confusing, but let’s elaborate on our hypothetical in order to explain what it means.
Assume that in June 2015 (a year after the grant date) the value of Startup’s stock has increased to $30 per share and after that, it continues to increase so that it is $40 per share in June 2016, $70 per share in June 2017, and $300 per share in June 2018 (when the last shares vest). Assuming that Jane remains employed for the duration of her time-based vesting period, here are Jane’s income inclusions:
- June 2, 2015: Ordinary income inclusion of $7,497.50, which is the result of 25% of Jane’s shares vesting that day: 250 shares * $30/share = $7,500 less $2.50 (her cost). This results in $2,774.08 of tax.
- June 2, 2016: Ordinary income inclusion of $9,997.50 because 250 shares * $40/share = $10,000 less $2.50 (her cost). This results in $3,699.08 of tax.
- June 2, 2017: Ordinary income inclusion of $17,497.50 because 250 shares * $70/share = $17,500 less $2.50 (her cost). This results in $6,474.08 of tax.
- June 2, 2018: Ordinary income inclusion of $74,997.50 because 250 shares * $300/share = $75,000 less $2.50 (her cost). This results in $27,749.08 of tax.
In sum, by not making the 83(b) Election, Jane will recognize $109,990 in income, resulting in $40,696.30 of tax she must pay at the federal level.
Moreover, by not making her 83(b) Election, Jane’s holding period for each tranche of shares begins on the vesting date for that tranche (rather than on the date she first received the shares). As a result, her first tranche of shares would not be eligible for long-term capital gain treatment until after June 2, 2016 and her final tranche would not be eligible until after June 2, 2019, five years after the date of grant. Similarly, Jane’s eligibility for QSBS (to the extent applicable) is deferred until after June 2, 2020 for her first tranche and after June 2, 2023 for her final tranche (which is nine years after grant).
Note: Adding to the complexity and uncertainty, where an 83(b) Election is not made Jane and Startup would be determining the fair market value of the shares at each vesting date. In our example, we provided only four vesting dates, but we more typically see vesting structured as a one-year cliff with monthly or quarterly vesting in equal amounts thereafter. See, for instance, Ed Zimmerman, “Weekend Read: If the Vest Doesn’t Fit…Option Vesting at Startups,” The Accelerators, Wall Street Journal (Mar. 28, 2014). Of course, four-year vesting on a one-year cliff with subsequent monthly installments would mean valuing your shares 37 times!
ADDING AN EXIT TO OUR EXAMPLE: Assume further that Jane sells her stock on January 1, 2019 for $1,000 per share (or $1 million in aggregate for all her shares).
RESULTS OF EXIT9ABSENT THE 83(b) ELECTION: Because Jane had not made the 83(b) Election, 75% of the gain she realized at exit is taxed at long-term capital gains rates and 25% is taxed at short-term capital gains rate (her last tranche would not become eligible until after June 2, 2019). Jane’s basis in her shares is $110,000 (which is the sum of her $109,990 of prior income inclusion for the stock plus her $10 cost). Accordingly, on sale Jane recognizes $890,000 of gain, resulting in $207,750 of tax at the federal level (75% at 20% and the rest at 37%). When you add her federal tax due on gain (that $207,750) to the tax she paid as the shares vested (the $40,696.30 above), Jane has paid a total of $248,446.30 in federal taxes as a result of the issuance and sale of her fully vested shares.
Additionally, NONE of her shares are QSBS eligible as of the exit date, although there may still be an opportunity to do a QSBS rollover under Section 1045 (see the Zimmerman/Silikovitz QSBS Article). Notably, because the QSBS holding period starts running from the date the shares vested, Jane is much more likely to have lost the ability to have good QSBS at the time of sale because, for instance (1) on a later vesting date, Startup’s assets may be more likely to exceed $50 million (which would disqualify Startup as a qualified small business), (2) Startup may have done one or more secondary sales or other redemptions (whether or not in connection with venture financings) which could be deemed disqualifying redemptions for QSBS purposes, or (3) starting the holding period later simply meant that while she sold her shares more than five years after the date she received them, she did not hold them for more than five years from the date on which those shares vested.
RESULTS OF EXIT WITH A TIMELY/VALID 83(b) ELECTION: In contrast, by timely and properly filing her 83(b) Election, Jane started the clock for long-term capital gain and QSBS (if eligible) at receipt of the shares. Accordingly, all of Jane’s shares would be subject to long-term gain.
Not QSBS: If the sale occurs on January 1, 2019, which would mean that Jane had not satisfied QSBS’s five year hold period on any of her shares, Jane’s shares were not eligible for QSBS benefits. As a result of that sale, Jane recognizes $990,000 of gain (her basis is $10,000, which is the sum of her $9,990 prior income inclusion when she made the 83(b) Election plus the $10 cost she paid for the shares), resulting in $198,000 of federal tax on gain. When you add what Jane pays at issuance to what she pays at exit, Jane pays an aggregate of $201,696.30 of federal tax as a result of the issuance and sale of her shares.
QSBS: Under our example, Jane would not have held the shares for the necessary five-year period for QSBS, but if Jane waited another six months and sold the shares after June 2, 2019, and assuming that Jane was a qualified holder and her shares were otherwise eligible for QSBS benefits on sale, Jane would pay zero in federal tax on sale because her gain falls well below the limit of the exclusion on gain provided for QSBS because that exclusion equals the greater of $10,000,000 or 10 times the stockholder’s cost. Moreover, if Jane were a New York State resident taxpayer at the time of her exit, she would also have paid $0 in State tax because New York follows the federal tax law for QSBS (see the Zimmerman/Silikovitz QSBS Article, note that different States follow, do not follow or modify QSBS benefits). To be clear, this means that, in aggregate, Jane pays only $3,696.30 of federal tax as a result of the issuance and $1 million sale of shares in the context of those shares qualifying for both QSBS and long-term capital gain treatment because of the 83(b) Election she had made.
TOTAL TAXES PAID & EFFECTIVE TAX RATE: In our example, Jane saved $46,750 in federal taxes on the issuance and subsequent sale of her shares by having made the 83(b) Election (where QSBS benefits do not apply). In other words, Jane’s total effective federal tax rate on her income and gain inclusions would be 25.1% (where she has not made the 83(b) Election) as compared to 20.37% (where she has she made the 83(b) Election). In that instance, not making the 83(b) Election has cost Jane either a 4.73% “spread” or a 23.2% extra payment to the IRS for her federal taxes.
In addition to the above increased tax burden flowing from not having made the 83(b) Election, Jane’s phantom income ($109,990 without the 83(b) Election as compared to $9,990 with it) also impacts employment taxes (for employer and employee) and has ramifications for withholding (at each vesting date), creating additional administrative burdens when Jane does not make the 83(b) Election.
In general, it makes sense to make the 83(b) Election where you can afford to take the stock into income at the time of receipt, especially where the fair market value of the restricted stock is higher upon vesting or where the stock does not appreciate as meaningfully after vesting as it did between receiving the stock and vesting. Of course, it’s hard to foretell the future value of the shares. But you need not make the 83(b) Election as to all shares, which brings us to the next discussion.
Must You Elect as to all the Shares?
No. If the tax burden of making the 83(b) Election is more than you (as the founder or executive) want or can actually pay, you can decide to make the 83(b) Election as to some rather than all the shares.
For instance, if instead of $10,000 in aggregate value, Jane’s shares on issuance had an aggregate fair market value of $200,000, Jane’s resulting federal income tax upon making her 83(b) Election would be $73,996.30. In that instance, Jane may decide that she is comfortable taking a lesser amount into income on the issuance of the shares and can make her 83(b) Election for $10,000 worth of the shares (for instance), agreeing with Startup that those shares vest first to further delay other income inclusion events. She and Startup may also decide to take the rest of her equity as stock options to avoid the then-unknown and potentially large phantom income consequences of having other shares vest, especially if those shares climb in value. Of course, stock options do not start the clock on capital gain or QSBS (you have to exercise the options and acquire the shares first), but that is a tradeoff if you cannot afford (or simply do not want) to pay the taxes arising from the phantom income triggered by receiving the shares.
Is it Always Beneficial to Make an 83(b) Election?
No. We have shown the upside in situations where the stock appreciates after the founder receives her shares. There are, however, numerous situations in which the 83(b) Election yields a bad result. For instance, it may not be tax efficient to make an 83(b) Election if the founder then forfeits the stock by, for example, leaving employment before the time-based vesting restrictions lapse. While you can take a loss deduction for any amount you actually paid to the company for the shares, (1) there is no deduction in respect of forfeited shares (in other words, you can take a loss deduction only to the extent that the shares were redeemed by the company for less than the amount you paid for the shares), and (2) it is very often the case that the founder paid little or nothing for their shares subject to the forfeiture restrictions.
Obviously, if the shares do not appreciate in value, an 83(b) Election will not yield good results even if the shares are not forfeited. For example, if an 83(b) Election is made, triggering an ordinary income inclusion, a later sale at a loss will result in capital loss. The capital loss cannot be applied to offset the earlier income inclusion and because it is a capital loss, it can only be used to offset capital gains and up to $3,000 of ordinary income per year. So, again, the founder can be in a situation where she had an ordinary income inclusion that is not fully offset by a subsequent tax event.
Additionally, in our experience, people deciding whether to make an 83(b) Election focus less on what happens if, after the 83(b) Election, the shares experience meaningful volatility. To illustrate this point, let’s adjust our example, to apply customary four-year vesting with a one-year cliff and monthly vesting thereafter. In that situation, when Jane will have 37 vesting dates and will be valuing the stock at fair market value 37 times to determine her phantom income at each vesting date. If the stock is very volatile, it can be extremely difficult to anticipate whether making the 83(b) Election will be better or worse.
Accordingly, when deciding whether to make an 83(b) Election, you should always consider your ability to pay taxes at the time of receiving the shares, your likelihood of staying through all the vesting dates, your view of the likely appreciation throughout the vesting period, and the eligibility of the shares for QSBS treatment (which makes it more compelling to start the clock early), among other factors.
Do Stock Options, LLC Interests, and RSUs Trigger 83(b)?
Clients often ask us whether the following trigger (or create an opportunity to make) an 83(b) Election: stock options, the grant of an interest (equity) in a limited liability company (LLC), or a restricted stock unit (or “RSU”). We consider each below, but we start with the premise that in order for Section 83 to apply, the service provider must receive “property,” as Section 83 defines that term.
Stock Options and Section 83
As a general rule, an option to purchase stock is not treated as a transfer of the underlying stock. The IRS does not generally treat stock options that are not actively traded on an established market as themselves being treated as “property” having an ascertainable fair market value. Therefore the IRS does not generally treat stock options as taxable on grant or subject to tax on vesting. If, however, a service provider exercises a stock option and the resulting shares are subject to vesting, then Section 83 applies to that share issuance and the service provider should consider making an 83(b) Election within 30 days of the date on which the service provider exercises the option. Special rules apply if a deeply discounted option is issued (which, for tax purposes might actually be treated as an equity grant) or if there is a public market for the option itself (as opposed to a market solely for the shares of stock underlying the option). Also, tax can result under a different Code provision, Section 409A, if options are issued with a strike price that is less than the fair market value of the underlying stock.10
LLC Interests and Section 83
Equity in an LLC (or another entity taxed as a partnership) is generally treated as “property” for purposes of Section 83, subject to the same rules as discussed above regarding stock in a C corporation. However, special rules apply to certain types of LLC (and other tax partnership) equity called “profits interests” that result in an 83(b) Election being protective, or unnecessary, in some circumstances. Conversion from an LLC to a corporation (whether by merger or by simply checking the box to treat the LLC as a corporation) can also give rise to an 83(b) Election opportunity – even if you have held the equity in the LLC for quite some time. Consequently, always seek tax guidance when converting from an LLC to a corporation and because going in the other direction (converting from a corporation to an LLC) is generally a taxable event, you should always seek tax guidance before embarking on that type of conversion too.
RSUs and Section 83
RSUs (or restricted stock units) are not “property” for purposes of Section 83. Accordingly, an RSU grant would not entitle a founder (or other service provider) to make an 83(b) Election with respect to that RSU grant. RSUs are a contractual commitment to transfer stock or a cash equivalent upon satisfying certain vesting conditions. Unlike the grant of restricted stock, there is no actual stock transferred at the time of granting the RSU. However, as in the case of options, if an RSU is settled in stock and the stock is subject to vesting or other forfeiture conditions, the service provider should consider making an 83(b) Election within 30 days of the day of receiving that stock.
B Corporation and Public Benefit Corporation Stock and Section 83
We increasingly also field the question of whether B corporations and Public Benefit Corporations are treated as C corporations for tax purposes and the answer is yes, for tax purposes, they are the same thing. Also, while S corporations and C corporations are not the same for tax purposes (and S corporations can have really painful consequences in the QSBS context – see the Zimmerman/Silikovitz QSBS Article), receiving S corporation shares subject to vesting also implicates Section 83 and the question of whether to make an 83(b) Election. We very rarely see startups use the S corporation format and given the restrictions applicable to S corporations (e.g., S corporations can only have one class or stock, shareholders can generally only be U.S. individuals and certain trusts) and the consequences under QSBS of using an S corporation (generally, ineligibility for QSBS benefits), we rarely encourage the use of an S corporation for venture-backed startups.
Is Founder Vesting Typical in Venture-Backed Companies?
The National Venture Capital Association (NVCA) created and regularly update Model Legal Documents for Venture Deals.11 The Model Term Sheet (at page 14 of the form last revised January 2019) requires the founders to subject their shares to risk of forfeiture12 (also known as ‘vesting’):
Founders’ Stock: All Founders to own stock outright subject to Company right to buyback at
cost. Buyback right for [_]% for first [12 months] after Closing; thereafter,
right lapses in equal [monthly] increments over following [__] months.”
We are not suggesting that the NVCA Model Term Sheet is a source of truth, but this concept is also not new. Here, for instance, is Mark Suster’s 2009 explanation (with apologies to Sequoia – and see financial disclosure footnote):
“I’m putting millions of dollars in your company. My thesis is YOU. I need some protection
that you’re not fully or mostly vested where you could simply walk away with a large stake in
the company, screwing not just me but the entire employee base of the company. I’m not
Sequoia. I’m not looking to bring in a new team to replace you. If you leave my thesis is largely
out the door.
Without proper vesting you also place a risk on all other co-founders. In my first company
there was no vesting in the seed round. One of the co-founders walked within the first year. He
walked with 1/3rd of the company. It was naive and stupid on my part. I didn’t understand the
issue back then.”
What’s the Difference Between Vesting and Reverse Vesting?
Not much, if anything. People use vesting to describe the situation in which you have an option grant that you cannot exercise until it “vests” (over time). In contrast, when you receive a grant of stock that is subject to risk of forfeiture, that stock is in your hands today and it “reverse vests” (meaning your risk of forfeiture goes away over time). But these are imprecise terms rather than statutory terms or true terms of art. We very often speak of restricted stock as “vesting” rather than reverse vesting, because both explain the concept – sure you hold the shares, but the restrictions lapse as the stock vests. Do not get hung up on the nomenclature for this particular point.
What Does a “Substantial Risk of Forfeiture” Mean?
Although this article has thus far focused on stock subject to time-based vesting, an 83(b) Election is implicated anytime a founder receives stock that is both (1) not “transferable” and (2) “subject to a substantial risk of forfeiture.” The IRS issued Treasury Regulations under Section 83 elaborating on the terms “transferable” and “substantial risk of forfeiture.”
Generally, “if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced,” there is no “substantial risk of forfeiture.”13 While there are additional exclusions and twists and turns, here’s the core of the Treasury Regulation (noting that the Treasury Regulations focus on property, which includes stock, but could equally apply to other property):
conditioned, directly or indirectly, upon the future performance (or refraining from
We are not complaining about the circularity of the regulation by noting that the above snippet of the definition uses the word “substantial” three times. So, when examining the facts and circumstances at the time of the transfer, the possibility of forfeiture cannot be illusory or purely speculative, but there has to be a real risk of losing the stock itself and of losing value. Accordingly, stock (or other property) “is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property.”15 But, of course, these regulations explain that merely taking market risk on the stock price does not mean that the stock is subject to substantial risk of forfeiture: “The risk that the value of property will decline during a certain period of time does not constitute a substantial risk of forfeiture.”16 The Treasury Regulations outline numerous factors that could lead to (or against) the conclusion that the risk of forfeiture is substantial. These factors include – but are not at all limited to – the regularity of performing the services, the time spent performing services, the employee’s position within the employer’s hierarchy, the employee’s relation to the employer’s officers and directors, and even the employee’s health, as well as “past actions of the employer in enforcing the provisions of the restrictions.”17 In other words, the IRS did not come to play; rather the IRS wants to ensure that this is a flexible and nuanced analysis. The Treasury Regulations then spend almost 1,500 words on examples.18
While this article focuses on time-based vesting (because it is so customary in the startup/growth company market), vesting can also arise from other conditions. For instance, the regulations expressly explain that stock can be “subject to substantial risk of forfeiture” where vesting is conditioned on the company’s total earnings increasing. Conversely, the regulations state that a requirement that stock be returned if the founder is discharged for cause or for committing a crime is not considered to result in a substantial risk of forfeiture.19 Also note that for public company stock, special rules apply to stock, where the sale of which could give rise to a suit under Section 16(b) of the Securities Exchange Act.20
Stock (or other property) is transferable, under these Treasury Regulations if the service provider can dispose of the stock without requiring the transferee to forfeit the stock (or its value) if the forfeiture conditions materialize.21 This subsection of the regulation also clarifies that the IRS will not deem stock to be “transferable” (for Section 83 purposes) merely because the service provider is able to designate a beneficiary to receive the stock upon her death.
Also, in order for stock to be subject to Section 83 generally, the stock must be “transferred” for purposes of Section 83. Stock is not treated as transferred if it must be returned for no consideration (or an amount not approaching fair market value) upon a condition that is certain to occur, such as the termination of employment.22
In short, whenever equity is issued subject to restrictions, experienced tax counsel should be consulted on the tax consequences of the grant and whether an 83(b) Election is implicated.
Tactics: How Should I Make the Election and What Should I Keep/Give the Company?
The Treasury Regulations under Section 83 describe how an 83(b) Election is actually made. Specifically, the founder files with the internal revenue office with which they file their income tax return a signed statement that provides:
- information regarding the taxpayer making the election (name, address, taxpayer identification number),
- a description of the property with respect to which the election is being made,
- the transfer date and relevant taxable year for which the election is being made,
- the nature of the restrictions to which the property is subject,
- the fair market value at the time of transfer (as determined for this purpose under Section 83),
- the amount, if any, paid for the property, and
- a statement that copies have been furnished to the person for whom the services are performed any certain transferees (if relevant).
As stated above, the 83(b) Election form must be filed not later than 30 days after the date the property was transferred and may be filed before the date of transfer. And once made, in only very special circumstances can the taxpayer revoke or amend that 83(b) Election.
M&A Diligence & Venture Deal Representations and Your 83(b) Election
We recommend that both the company and founders keep good records of the filing of 83(b) Elections (including mailing and delivery receipt – so we encourage certified mail, return receipt requested) to rebut any possible assertion that you missed your relevant filing deadline. In sale transactions, as part of the diligence process, buyers ask the company for copies of any 83(b) Elections that were made in respect of the company’s stock. In certain circumstances, the acquiror may insist that if a copy of the election cannot be found, the parties act as if the election was not made.
If you needed further encouragement to ensure that you (as the taxpayer or as an executive or board member at the company issuing the shares) retain copies, here is the Section 83(b) representation and warranty in the NVCA’s Model Stock Purchase Agreement for Venture Deals (version updated January 2018; see above for more on the NVCA model documents):
“[2.2.2 [83(b) Elections To the Company’s knowledge, all elections and notices under Section
83(b) of the Code have been or will be timely filed by all individuals who have acquired
unvested shares of the Company’s Common Stock.]”
The representation is accompanied by a footnote stating: “This representation is fairly standard in West Coast venture financing transactions; it is much less common in financings originating on the East Coast.” We frequently see versions of this representation, whether in East or West Coast deals and sometimes we see versions23 of it that have included “and the Company has retained a copy of each such filing.”
What’s the Relevance of Section 409A to Section 83(b)?
Because an 83(b) Election requires that you take into income the difference between what the recipient paid for the shares and the fair market value at the time of grant, clients naturally ask us whether Section 409A valuations apply to Section 83(b). Put another way, founders and board members routinely ask that because we use 409A valuation reports to determine the fair market value of common stock for purposes of granting stock options, it ought to apply to stock grants as well. The answer is, not really.
As Ed Zimmerman and Brian Silikovitz wrote in “How Startup Founder Stock Often Triggers Unnecessary Personal Tax Hits” in Forbes (January 6, 2015, we refer to this article as the “Zimmerman/Silikovitz Founder Stock Article”):
“409A doesn’t specifically apply to giving someone stock, whether outright or subject to risk of
forfeiture (vesting). However, and we think this is a pretty big “however”, it would be pretty
awkward to grant stock options based on a fresh 409A valuation report that the board has
adopted and then give someone shares of stock at a much lower valuation at about the same
time. That would mean that the board, acting on behalf of the company, would be taking
inconsistent tax positions regarding value of a single share of the company’s common
stock. Let’s avoid doing that!”
Moreover, Section 409A does not provide a ‘safe harbor’ when you use a valid/fresh report the right way. It provides a rebuttable presumption that the company’s board got it right, but even that presumption can be rebutted, as the Zimmerman/Silikovitz Founder Stock Article explains:
“The IRS wanted to help all of us by offering some degree of clarity and ‘protection,’ which I’d
describe as complex and a bit fuzzy. The ‘protection’ in this instance, means that if you do what
the IRS prescribes, the IRS will give you the benefit of a “rebuttable presumption” that you
didn’t screw things up. A “rebuttable presumption” is NOT a “safe harbor;” rather it’s just a
presumption that the IRS can overcome by showing that the valuation method or its
application was “grossly unreasonable,” whatever that means.”
Section 83(b) is a trap within a trap and the IRS’s desire for facts and circumstances-based analysis means that it will generally be very helpful to obtain tax guidance from professionals who have helped numerous others navigate the decision of whether to file an 83(b) Election. Understanding the consequences of failing to file and when the clock begins for QSBS and long-term capital gains will also be very important.