There are many tax planning techniques and optimizations to consider when dealing with equity compensation received from private and public companies, more than can be covered in one article. And it’s important to give this the attention it deserves: over your career, thorough tax planning on a regular basis can save you significant amounts of money and add to your net worth.
Many of these considerations can be explored with a financial advisor at various times in your company’s life. But when founding a tech startup company, there is one you should be aware of right from the beginning.
Filing an 83(b) Election
Let’s say you and a couple of friends or colleagues decide to start a company. You used Clerky or Cooley GO to incorporate your startup as a C corporation in Delaware. You issued stock to yourselves as founders—some shares outright and some subject to a standard four-year vesting schedule. So far, so good. You’re on track.
The incorporation package included something called an 83(b) election, but you didn’t understand what that was all about, and you were busy writing code, so you ignored it. That’s a mistake. A mistake that might cost you tens of thousands of dollars or more in extra tax if the company is successful.
The shares you received outright are a form of compensation, and their value is taxable as ordinary income in the year you received them. This really isn’t a problem because the value of the shares is low. For example, if you received 400,000 shares and the value of the shares was $0.00001 when you received them, you owe tax at ordinary income tax rates on $4. No big deal.
Later, when you sell the shares, the increase in the value of the shares above $0.00001 will be taxed at the favorable federal, long-term capital gains tax rate, assuming you hold the shares for at least one year.
The shares you received that are subject to vesting are also compensation income, and their value is taxable to you at the higher ordinary income tax rates. The difference is, the value of the shares becomes taxable to you as the shares vest, not when they are granted. This is where the problems start.
For example, let’s say you were granted 2,000,000 shares subject to vesting. One year after the company was founded, the value of the stock is $0.10 per share and 25% of your shares have vested. At that time, you will owe ordinary income tax on $50,000 of compensation income. To make matters worse, because the company is still private, you won’t be able to sell any shares to raise cash to pay the tax—you’ll have to come up with the cash to pay the tax from other assets you own.
Let’s say in the following year, the value of the company is $0.50 per share and another 25% of your stock has vested. At that point, you would owe ordinary income tax on another $250,000 of compensation income and still not be able to sell shares to pay the tax. You see the pattern. As the stock price increases each year and vesting continues, the problem gets worse.
Filing an 83(b) election solves this problem. With an 83(b) election, you are telling the Internal Revenue Service (IRS) that you would like your shares that are subject to vesting to be treated as if they are all vested at the time the shares are granted.
In doing so, you agree to pay ordinary income tax on the shares you received based on the low price per share when they were granted, just as is the case for the outright shares, and you won’t have to pay tax later as shares vest at higher share prices as the company grows.
In the example above, with the 83(b) election, you would owe ordinary income tax on $4 of income for the outright shares and $20 of income on the shares that are subject to vesting, for a total income of $24. The tax on $24 is negligible.
Going forward, all the gain in the shares, whether granted outright or subject to vesting, will be taxed at the lower long-term capital gains rates instead of the higher ordinary income tax rates, assuming you hold the shares for at least one year.
Currently, the highest federal tax rate on ordinary income is 37%, and the highest federal tax rate on long-term capital gains rate is 20%. The 17% difference between tax rates means that the tax savings from using an 83(b) election can be substantial.
In addition to starting the one-year holding period to qualify for long-term capital gains treatment when you later sell your shares, the 83(b) election also starts the five-year holding period on the shares subject to vesting as required for the qualified small business stock (QSBS) exclusion.
With QSBS, some or all the gain in the value of your shares may be excludable from federal income tax (and in some states, state income tax too). QSBS is another powerful reason to file an 83(b) election.
The 83(b) election has a strict filing deadline. It must be filed within 30 days of your shares being granted, and there are no exceptions for late filing. The IRS instructions for filing an 83(b) are a little difficult to find—they are included in Revenue Procedure 2012-29, which includes a sample 83(b) election form on page 9.
The incorporation package you use for your company’s founding documents may include instructions for filing your 83(b) election as well. Be sure to check with your tax advisor if you have any questions about how to properly file your 83(b) election.
There are hundreds of things to learn and details to process when founding a company. Being aware of this important detail—the 83(b) election—is an important place to start. Otherwise, you may jeopardize the financial results you’re working so hard to achieve before you even get started.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’re thinking about hiring a wealth manager and would like to understand how ongoing tax planning can help you build net worth, schedule a complimentary consultation.
