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 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 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. Quit your job to end the vesting and your increasing tax liability as your company becomes successful. We have, unfortunately, seen this happen before. In very successful startups, your tax liability could quickly outstrip your annual paycheck.
Positives: Stops the vesting and future tax liability.
Negatives: You are out of work. You lose the future upside that you worked hard for in the early years. Company loses a founder/key employee. Doesn't cure the problem for any stock that has already vested.
2. Surrender any remaining unvested shares back to the Company. The Company could then re-grant a new option equal to the surrendered unvested shares.
Positives: Stops the vesting and future tax liability.
Negatives: New option must be granted at the current FMV which is likely higher than the original stock surrendered (lose some upside). Doesn't cure the problem for any stock that has already vested. Must be done carefully to avoid tax fraud. Looks strange on the Company's cap table and will have to be explained to all new investors, lenders and acquirers. Many tax advisers believe that this may not be an effective solution as the IRS or courts may not give effect to the surrender/re-grant.
3. Fully vest the remaining unvested stock immediately.
Positives: Locks the size of the tax problem on the date that vesting is accelerated.
Negatives: You will owe tax on all shares where vesting is accelerated on the date of acceleration. If there is a "spread" on the acceleration date, you will pay taxes immediately on the accelerated shares (could be substantial). Doesn't cure the problem for any stock that has already vested. Investors/Board and future potential investors and acquirers may object because fully vesting may make it easier for the employee to leave the company.
4. Change the repurchase price on unvested stock from the original exercise price to the then current Fair Market Value. In the IRS's view, if the Company has to pay the full FMV on repurchase, there is no "substantial risk of forfeiture" on the stock.
Positives: Locks the size of the tax problem on the date that the repurchase price is increased. "
Negatives: Doesn't cure the problem for any stock that has already vested. Investors/Board and future potential investors and acquirers may object because employee's departure means the Company has to pay a substantial amount to repurchase the unvested shares or not repurchase and let the departing employee keep the unvested stock. Employee may have less incentive to stay with the Company because they get FMV or keep stock on departure.
5. Make the stock transferable to a third party without being subject to vesting following the transfer. The IRS does not consider a stock being subject to a "substantial risk of forfeiture" if the stock is transferable to a third party who is not subject to such restrictions following the transfer. Some practitioners say that the IRS would view such stock as fully vested for tax purposes on the date the transfer amendment is signed. The amendment could allow transfer to one or more third parties. The agreement could provide that the employee would pay the fair market value back to the Company if there is a transfer and the employee leaves the Company and the shares would have been unvested at that time. The key is the ability to transfer to a third party without restriction even if such transfer is unlikely to ever occur.
Positives: Locks the size of the tax problem on the date that the transfer amendment is signed. Does not alter the original exercise price for the employee or the repurchase price for any unvested shares. Does not alter the actual time based vesting schedule for the employee.
Negatives: You owe tax on any spread on the remaining unvested shares as of the date the transfer amendment is signed. Doesn't cure the problem 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.