If you receive stock subject to vesting (a "substantial risk of forfeiture" is the IRS term), it is critical to timely file your 83(b) election within the 30-day window. DON'T MISS THIS WINDOW. Avoiding a problem is much easier than trying to fix one. Here's a quick summary of how vesting stock is treated by the IRS followed by some potential remedies for missed 83(b) elections.
THIS IS NOT LEGAL OR TAX ADVICE. JUST A HIGH LEVEL DISCUSSION. YOU SHOULD ALWAYS CONSULT COMPETENT LEGAL COUNSEL AND TAX ADVISERS WHEN MAKING DECISIONS REGARDING STOCK OPTIONS. TAX LIABILITY WILL VARY DEPENDING UPON EACH TAXPAYER'S INDIVIDUAL CIRCUMSTANCES.
VESTING AND IRC 83(b) BASICS
When you receive stock subject to vesting from a startup, the default tax rule is that you pay tax on the stock as it vests over time (typically a 4 year period). If your startup increases in value over these 4 years (which is sort of the whole point of doing a startup), you would be taxed on the shares that vest on the date that they vest. You would be taxed on the "spread" on each share - the amount that the fair market value on the vesting date exceeds your exercise price.
A SIMPLE EXAMPLE: You were granted 40,000 shares that vest 10,000 shares per year. You got in early so your exercise price is $0.01 per share, which is the fair market value on the grant date. You immediately purchase all 40,000 option shares on the grant date.
TAX WITH NO 83(b) ELECTION. Since no shares are vested initially, you don't owe any tax on the exercise date, but you will owe tax on each anniversary when your stock actually vests. Here is the potential future tax impact:
Year 1: 10,000 shares vest and FMV is now $0.10 - you now have taxable income of 10,000 * ($0.10 - $0.01) or $900 of taxable income.
Year 2: Another 10,000 shares vest and FMV is now $1.00 - you have taxable income of 10,000 * ($1.00 - $0.01) or $9,900 of taxable income
Year 3: Another 10,000 shares vest and FMV is now $5.00 - you have taxable income of 10,000 * ($5.00 - $0.01) or $49,900 of taxable income
Year 4: The last 10,000 shares vest and FMV is now $10.00 - you have taxable income of 10,000 * ($10.00 - $0.01) or $99,900 of taxable income.
Taxable Income WITHOUT an 83(b) election: $160,600
Tax due WITHOUT an 83(b) election: $32,000 to $56,000 (assuming a 20-35% tax rate)
Worse yet - your stock is restricted and illiquid - you can't sell the stock to pay your tax bill and would have to pay this out of your pocket prior to the sale or IPO of your company.
TAX WITH AN 83(b) ELECTION. Filing an 83(b) election with the IRS within the 30-day window tells the IRS that you wish to be taxed on the entire option grant upon the date of exercise (not when the stock actually vests in the future). The tax liability prior to sale of your stock changes drastically:
Date of Exercise: Taxed on all 40,000 shares on date of exercise - you now have taxable income of 40,000 * ($0.01 - $0.01) or $0 of taxable income. [Remember the fair market value equals your exercise price on the exercise date so there is no spread on the shares on the date of exercise.]
Future Vesting Dates: Ignored - you have already paid your tax on the date of exercise.
Taxable Income WITH an 83(b) election: $0
Tax due WITH an 83(b) election: $0
That's a huge tax difference when you timely file a 1-page 83(b) election with the IRS within the 30-day window.
WHAT HAPPENS IF YOU MISS THE 30-DAY WINDOW FOR FILING THE 83(B) ELECTION?
Unfortunately, the IRS will not accept your election, and your election will not be valid, if you file after the end of the 30-day window.
POTENTIAL SOLUTIONS FOR A MISSED 83(B) DEADLINE
Your options are very limited when you miss this window and most lawyers and tax advisers would offer the following limited solutions:
WARNING: NEVER "BACKDATE" OR "CORRECT" OLD PAPERWORK. THERE IS LIKELY A SUBSTANTIAL EMAIL/DOCUMENTATION/BANK DEPOSIT TRAIL. DON'T COMMIT TAX FRAUD OR BREAK THE LAW. CRITICAL TO GET COMPETENT PROFESSIONAL ADVICE BEFORE TAKING ANY ACTIONS.
1. Contemplate resigning from your position to cease the vesting process and curb the growth of your tax liability as the company flourishes. Regrettably, this scenario has been observed before. In the case of highly successful startups, tax liabilities may rapidly exceed one's annual earnings.
Advantages: Halts the vesting process and future tax liabilities.
Disadvantages: Results in unemployment, forfeits potential future gains achieved through hard work in the company's early stages, and leads to the loss of a founder or key employee. Additionally, it does not address the issue for any stock that has already vested.
2. Return any outstanding unvested shares to the company. Subsequently, the company can issue a new option equivalent to the relinquished unvested shares.
Advantages: Terminates the vesting process and future tax liabilities.
Disadvantages: The new option needs to be granted at the current FMV, which is likely higher than the original stock returned (resulting in a loss of potential gains). It does not resolve the issue for any stock that has already vested. Proper care must be taken to avoid tax fraud. This action may appear odd on the company's capitalization table and will require explanation to all new investors, lenders, and acquirers. Many tax advisors argue that this may not be an effective solution, as the IRS or courts might not recognize the surrender and re-grant process.
3. Accelerate the vesting of the remaining unvested stock immediately.
Advantages: Solidifies the tax issue's scope at the time the vesting is expedited.
Disadvantages: Taxes will be due on all shares where vesting is accelerated on the date of acceleration. If there is a "spread" on the acceleration date, immediate taxes will be owed on the expedited shares (potentially a significant amount). It does not address the issue for any stock that has already vested. Investors, board members, and future potential investors and acquirers might object, as full vesting could make it easier for the employee to leave the company.
4. Modify the repurchase price for unvested stock from the original exercise price to the current Fair Market Value (FMV). According to the IRS, if the Company has to pay the full FMV upon repurchase, there is no "substantial risk of forfeiture" for the stock.
Advantages: Solidifies the tax issue's scope at the time the repurchase price is increased.
Disadvantages: It does not address the issue for any stock that has already vested. Investors, board members, and future potential investors and acquirers might object, as the employee's departure would require the Company to pay a significant amount to repurchase the unvested shares or choose not to repurchase and allow the departing employee to keep the unvested stock. The employee may have less incentive to remain with the Company because they would receive FMV or retain stock upon departure.
5. Make the stock transferable to a third party without vesting restrictions after the transfer. The IRS does not view stock as being subject to a "substantial risk of forfeiture" if it can be transferred to a third party without restrictions post-transfer. Some experts believe that the IRS would consider such stock as fully vested for tax purposes on the date the transfer amendment is signed. The amendment could allow transfers to one or more third parties. The agreement might stipulate that the employee pays the fair market value back to the Company if a transfer occurs and the employee leaves the Company when the shares would have been unvested. The crucial aspect is the ability to transfer to a third party without restriction, even if such a transfer is unlikely to happen.
Positives: Solidifies the tax issue's scope on the date the transfer amendment is signed. Does not change the original exercise price for the employee or the repurchase price for any unvested shares. Does not modify the actual time-based vesting schedule for the employee.
Negatives: You are liable for tax on any spread on the remaining unvested shares as of the date the transfer amendment is signed. It does not address the issue for any stock that has already vested.
Don't miss the 83(b) deadline if you have stock that vests. If an employee misses the 83(b) election deadline, there are several alternatives available to that may lessen the future tax liability of the employee for such a mistake. Which alternative is chosen will depend on the facts and circumstances, such as current spread on the stock over the exercise price, how much time has passed since the original option grant and/or exercise, future prospects for the Company and the individual's own financial and tax situation.
IF YOU HAVE MISSED AN 83(B) DEADLINE, IMMEDIATELY SEEK COMPETENT LEGAL AND TAX ADVICE BEFORE TAKING ANY ACTIONS.
How can Eton help?
Navigating the intricacies of stock options and 83(b) elections can be challenging. At Eton Venture Services, our experienced professionals are well-versed in the complexities of tax and legal implications associated with stock options and vesting. We can help you understand the process of making timely and appropriate 83(b) elections, and provide non-legal advice on potential remedies in case you have missed the deadline.
If you have missed the 83(b) election deadline or require assistance with stock options and related tax matters, don't hesitate to seek our professional guidance. At Eton Venture Services, we are dedicated to providing comprehensive, customized solutions that cater to your unique needs. Join the industry leaders that have trusted Eton to provide rigorous, audit-defensible, and optimized IRC 409A and ASC 718 valuations to assist in attracting, retaining, and incentivizing top talent which remaining in compliance with the law. Contact us today to experience the benefits of our exceptional client service and expertise.