By Amy Riedel
As we begin a new year and leave holiday celebrations behind, I am reminded of a less exciting event signaled by year-end: personal income taxes. For most people, December 31st marks a day of not only celebratory champagne countdowns, but also the end of their tax accounting year. For anyone who has started a business or invested in a business, this includes the personal tax consequences of that investment.
As startup attorneys, one of the questions we are most often asked by clients is whether to take an 83(b) election for their shares or interests in a company. While we are not tax attorneys, this post will give a general overview of when to consider taking one. As always, we recommend consulting with your accountant or tax attorney when making tax decisions.
Codified at 26 U.S.C. § 83(b) and otherwise known as an “83(b) election,” this statutory provision allows an individual who is acquiring property (e.g. stock) in exchange for services to pay taxes at the time the stock is awarded. This seems straightforward enough, right? We pay taxes at the time we receive payment for service rendered.
But what happens when stock is being awarded pursuant to a vesting schedule? A vesting schedule means that a specified amount of stock is reserved, but is only issued after certain periods of employment have been reached. Founders and employees often receive stock on a vesting schedule. Under the default rule, this schedule means that the shareholder would pay taxes on the shares as they were received over employment. Assuming that the company increases it stock valuation each year, the shareholder would be paying taxes on more highly valued shares as they are awarded over time.
Alternatively, the 83(b) election allows the shareholder to pay taxes on the entire award when it is made, rather than as the shares are vested. Again assuming that the company increases it stock valuation, this means that taxes will be paid at its lowest value, and the lowest net tax payment made. The shareholder is essentially betting that the value of the shares will increase over time and she will save money by paying at the current valuation.
The potential downside occurs if the shares instead drop in value, in which case the shareholder has paid taxes at a higher valuation than she would have made if she waited. This is the other side of the bet – the IRS betting against the shareholder and assuming that the shares will decrease in value over time.
So what do you do? For founders, the new company is likely at its lowest possible valuation (near zero). The tax payment will be minimal, it is unlikely that the stock could drop below its starting value, and even if it does, the related loss would be nominal. Further, any increases in the value of the stock after the election will be paid at capital gains rates, which are much lower than income tax rates. For employees, it becomes a riskier decision. We all anticipate that the companies we work for will increase in value, with the stock prices rising as a result, but such growth can be more difficult to anticipate in a well established company. Stock prices are, after all, fickle. Accordingly, such employees will need to do a more careful analysis of the company, its current valuation, and the risk/reward based on what the value of the potential tax savings (or losses) would be over time to determine if the 83(b) election makes the most sense.
Again, this is post is meant to be a primer; whether to make the 83(b) election (and how to make it) is a significant question that requires specific advice for each situation. And if anyone is still confused, or if you want more information, there is a great visual explanation of the 83(b) election at this blog.
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The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Amy Riedel at email@example.com