“You filed your Section 83(b) election, right?”
I gave a presentation a few years ago on how to fix a missed tax code Section 83(b) election. My phone started ringing the moment I returned to my office. Turns out, these get missed. Apparently, founders have other things to worry about during the 30 days after receiving their stock, like, um… starting a business.
But let’s back up.
What is a Section 83(b) election?
You and your buddy decide to start a company. But wait, what if this co-founder loses interest and leaves for a job, that, well, actually pays something? Turns out, he or she is wondering the same thing about you. So, you each agree that if you quit, you will forfeit your stock back to the company.
This forfeiture risk usually lapses over time. When a share of stock is no longer subject to this forfeiture risk, it is considered “vested.” A standard vesting schedule is 25% of the shares vesting after the first year of employment, and the rest vesting in equal installments over an additional three years. So, you stick around for four years and you get to keep all of your stock even if your service stops, or not infrequently a company has the right to repurchase your vested stock at fair market value, meaning you at least get the value of the stock when you leave employment.
Under regular tax rules, your stock would cause ordinary compensation income as it vests, on its value at the time of vesting. For example, perhaps when you start the company it is worth $0.0001 per share, but when it vests a year later the value has increased to $0.05. That might not sound so bad. But now let’s say you have 1,000,000 shares vesting. Which would you prefer: $100 of taxable income (~$40 of tax) at grant, or $50,000 of taxable income (~$20,000 of tax) on your first vesting date, with an additional tax on each subsequent vesting date? Remember, you have not received any cash, just private company stock. Any tax will require you to reach into your pocket to write a check.
So, Congress, wanting to be the hero, decides to allow a founder to choose to be taxed on the $100. How? By filing a Section 83(b) election.
If it’s so amazing, you say, why doesn’t everyone file one? Good question. I know a lawyer who actually has a vanity license plate that says “File83b”. You can’t say we lawyers aren’t trying to spread the word.
But the real problem is that a Section 83(b) election has to be filed, if at all, within 30 days of receiving the unvested stock. This is non-negotiable.
So how can a company help a founder fix a missed a Section 83(b) election?
I describe three alternatives below. These DO NOT fix any underwithholding that may have already occurred if a vesting date has come and gone. Rather, these fixes prevent future tax at vesting of the stock. Fix #3 is the fix I see used most often.
1. Surrender, then Regrant
You could have the founder surrender the stock and then grant an alternate form of equity. The new grant cannot simply be more restricted stock, though.
The new grant could be stock options or stock appreciation rights, as long as such awards are not early-exercisable. If the company is taxed as a partnership, the replacement award could probably be a profits interest, and maybe even with a catch-up if necessary.
The disadvantage of this fix is that there is a clear change to the business deal. New terms would have to be negotiated by both parties. That said, if the new award were an incentive stock option (see here for an explanation regarding the two types of stock options) folks may end up close to the same tax treatment at the end of the day, as long as the founder is not in alternative minimum tax land at the time the ISO is exercised, and the sale of any shares is a qualifying disposition. Similarly, a profits interest with a catch-up could result in very similar treatment to a capital interest grant.
2. Accelerate the Vesting or Remove the Right to Repurchase at Cost
A Section 83(b) election has the consequence of making stock taxable at grant, rather than as it vests. Ok, you say, let’s just accelerate the vesting!
A company could do that, as long as the parties aren’t secretly planning to resubject it to vesting.
A more nuanced version of this concept is to remove the right to repurchase at cost. You see, generally, a restricted stock agreement will either provide that:
- Unvested shares are forfeited upon termination of service, or
- The company can repurchase unvested shares for a certain period of time after termination of service at the original purchase price (or the lower of the fair market value and the original purchase price).
Under the tax rules, to accelerate the tax, you don’t have to eliminate the vesting concept altogether, you can instead just amend the award so that the company can only repurchase the unvested shares at fair market value on the date of the repurchase.
- Like all the fixes, it prevents a tax on the future vesting of the stock.
- However, this amendment (like #3 below) causes taxable compensation income to be immediately recognized by the stockholder on an amount equal to the value of the stock on the date of the amendment, minus the original purchase price if any. Put simply, if value has gone up since the date of grant, this will cause more tax than the Section 83(b) election would have caused.
My sense is that few companies are willing to use this fix. There was a reason why the stock was subjected to vesting in the first place, and the parties are usually not too excited about removing it.
3. Make the Stock Transferable
Many tax practitioners believe you can accelerate the tax to today (and thus prevent tax at vesting) if you make the unvested stock transferable to a small group of permitted transferees, such as large shareholders. It must be clear that the stock would become fully-vested if transferred. This can either be done in the restricted stock agreement or in a side-agreement.
Sometimes the parties want to add language requiring the stockholder to disgorge any profits obtained in such a transfer/sale, but I believe it is safer to allow the stockholder to retain any gain.
The parties tend to like this fix because it requires very little change to the business deal: the service provider keeps the restricted stock grant subject to the original vesting schedule. However, while the service provider would likely not take advantage of the new transferability, theoretically he or she could, and such a transfer would result in full vesting of the stock.
Also, remember that this fix causes tax on the current value of the unvested stock minus purchase price paid if any.
This post was originally published on LinkedIn. Mike Baker and Atrium frequently work together to advise clients with respect to tax code Section 83(b) elections. To keep informed on similar topics or to read other articles authored by Mike, follow him on LinkedIn.
 If day 30 is a weekend or a federal holiday, you can file the first regular business day after the 30-day deadline and your filing will still be timely.
 If the stock was purchased and the founder wants it to be repurchased (rather than forfeited), the qualified small business stock “significant redemption” prohibitions should be considered.
 The IRS has made clear that if the new grant is simply more stock it will not restart the 30-day clock for the Section 83(b) election. See Internal Revenue Service Chief Counsel Advice Memorandum 199910010.
 If an investor came onto the scene in the future and subjected it to vesting, I expect that would be ok.
 This is because, under Section 83, the default of taxation at vesting is only if the restricted stock is subject to both a substantial risk of forfeiture and a restriction on transferability.