Founders of startups usually purchase their common stock in their company pursuant to a restricted stock purchase agreement and a reverse vesting schedule. Generally, from the IRS perspective, this means that the stock is acquired when released from the vesting restrictions, which triggers in tax considerations.
A founder must make an 83(b) election by filing a form with the IRS within thirty (30) days of executing a restricted stock purchase agreement in order to avoid tax consequences. Generally, failing to make a timely 83(b) election with the IRS can lead to problematic tax consequences for a startup company founder or employee.
Under Section 83 of the Internal Revenue Code, the founder/employee would not recognize the income from the stock purchase (the difference between the fair market value of the stock and the price paid) until the time that the stock vests. Under a typical vesting schedule, the stock would vest four years after incorporation of the company. However, if a founder/employee makes a voluntary Section 83(b) election, the founder/employee recognizes “income” upon the purchase of the stock instead of the date that it becomes vested. Typically, the purchase price for the stock and the fair market value are the same on the date of purchase. Therefore, if an 83(b) election is made, there is no income recognized and no resulting tax. Thus, in a startup incorporation scenario, a founder/employee should almost always make an 83(b) election.
In that sense, Section 83(b) of the Internal Revenue Code permits the founders to elect to accelerate the taxation of restricted stock (i.e., stock subject to forfeiture) to the grant date, rather than the vesting date. As a result, the founder would pay ordinary income tax rates on the fair market value of the stock at the time of the grant (which presumably would be quite low or would be equal to the purchase price if such stock was purchased),with any subsequent appreciation of the stock being taxed at capital gains tax rates upon its sale.
Absent an 83(b) election, any subsequent appreciation of the stock would be subject to ordinary income tax rates at the time of the vesting. This could create a situation where a founder has significant tax liability, but no cash to pay for it. Generally, it is therefore advisable (subject to consultation with tax counsel) for any founder receiving restricted stock to make an 83(b) election with the IRS.
In order for an 83(b) election to be effective, the individual must file the election with the IRS no later than thirty (30) days after the purchase date of the stock. There are no exceptions to this timely filing rule. The election should be filed by sending a signed election form by certified mail, return receipt requested to the IRS Service Center where the individual files his/her tax returns. A copy of the election should be provided to the company, and another copy should be attached to the taxpayer’s federal income tax return for the year in which the property is acquired.