What to Know About Founder’s Equity and the 83(b) Election

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Imagine being completely oblivious to one of the most consequential personal finance decisions you may face in your financial journey. What’s more, what if you only had 30 days to make this decision and process the necessary paperwork? 

A founder or early-stage startup employee can face this exact scenario – and this step of their startup journey starts on day zero.

Below, we demystify the largely unknown 83(b) election and explore why this financial feature needs to be on the radar of founders and early-stage startup employees. 

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First, the Basics of Restricted Stock

Before diving into the 83(b) election, it’s necessary to understand the basics of restricted stock 

Restricted stock is given to employees, directors, and advisors in early-stage companies as a form of compensation. Since most early-stage companies are strapped for cash, they offer equity in the company to give early employees an opportunity to benefit from the growth of the business. 

This opportunity helps in a big way. It preserves cash that can be reinvested in the business to develop products and scale. If the venture turns out successful, this equity position can be worth a life-changing amount of money. 

The reason the stock is restricted is due to vesting conditions that may need to lapse; the restriction can also be on when the shareholder is able to sell the stock. Since restricted stock is typically granted at incorporation or shortly after, it’s often issued for a nominal cash payment (such as $0.0001 per share).

To fully own all the shares, most restricted stock requires that shareholders be active with the company for a certain number of years. It’s important you understand the terms and conditions of your grant agreement or work with an advisor that can help you navigate the financial jargon. 

Understanding (Potentially) Negotiable Equity Rights

Thoroughly understanding the equity agreement is essential. Why? It outlines the rights beyond the equity interest entered into between the employee and the company (which can be done at the time the stock is issued or later). 

A host of rights are often outlined in these agreements, such as:

  • Vesting provisions. Under a typical vesting schedule, the stock vests in monthly or quarterly increments over four years.
  • Accelerated vesting upon sale of the company. Vesting provisions on restricted stock may allow for acceleration of vesting following the sale of the company.
  • Right of first refusal. This gives the company or other founders the opportunity to purchase shares that a founder proposes to sell to a third party.
  • Co-sale provision. This gives the right to be a seller by providing an opportunity to participate in a sale by a third party.
  • Lock-up agreement. These prevent the sale of stock for a period following an initial public offering (IPO), which generally lasts 180 days and may be extended in certain circumstances.
  • Super-voting rights. It’s possible to give special voting rights to founding stock that may incorporate 10 or more votes per share, which includes well-known examples like Google, Facebook, and Twitter.

Because of the dynamic nature of startups, it’s best to consider these provisions in the earliest stages of the company.

Making Sense of the 83(b) Election

So, what exactly is the 83(b) election?

For starters, the IRS Section 83(b) election is an approach to minimizing the amount of tax you’ll pay as you vest your stock. By opting to make the 83(b) election and closely following the appropriate steps (more on that later!), you’re electing to pay ordinary income taxes earlier than required. 

You may be asking, “Why would I want to pay the tax sooner?” Well, by making this election and paying the taxes now, you can lock in a low stock value at the time of issuance (such as $0.0001 per share if a founding grant) in exchange for a better tax rate later if the vested shares are sold at a much higher price. 

Basically, you declare ownership early, and pay ordinary income taxes on your ownership when the stock is less valuable – and then pay the lower capital gains rate on the increase in value once sold. In essence, paying now is saving later.

To File or Not to File? 

Here is a real-world example of what goes into the decision of whether to file or not file.

Assume you receive 100,000 shares subject to vesting, worth $.01 per share at the time of grant, $1.50 at the time of vesting, and $4.50 per share when sold more than one year later. (We’ll also assume you are subject to the maximum ordinary income tax rather than long-term capital gains rate. For simplicity, we will not discuss employment or tax consequences.) 

Filing an 83(b) election verses not filing

Filing a section 83(b) election would have saved you $25,330! That’s a significant amount, but that’s not the end of the story given several other items to weigh.

Additional 83(b) Election Considerations 

While going through this process, you might want to ensure the rest of your financial house is in order with these 5 financial moves to make while working for a startup.

Once you get to this point in your startup journey, filing the 83(b) election comes with additional considerations. It prevents you from having a tax hit when the stock vests, which might be at a time where you don’t have cash to pay the tax. It also assumes you have the cash reserve on hand to pay the tax up front.

The 83(b) election also starts your long-term capital gains and qualified small business stock (QSBS) holding period clock earlier. This means you get the long-term capital gains rate if the sale of your shares occurs more than a year after grant, rather than a year after vesting. 

In the case of qualified small business stock, you can avoid federal tax entirely if the sale occurs more than five years after grant and certain other conditions are met. Stay tuned for more on QSBS in a future blog!  

So now you may be wondering, “If the 83(b) election is so beneficial, why doesn’t everyone file one?”

If you received restricted stock worth a nominal amount, it virtually always makes sense to file one. However, what if instead of receiving 100,000 shares of restricted stock worth $.01 per share, you received 100,000 shares of restricted stock worth $2.00 per share? 

In that scenario, filing the 83(b) election would immediately cause you tens of thousands of dollars in tax. If the company subsequently fails, especially before the stock vesting period is met, you would have been economically better off to not have filed the 83(b) election.

The Mechanics of Filing Your 83(b) Election 

How do I actually file the 83(b) election? Great question!

Your ducks need to be aligned if you intend to meet all the requirements. (Please note that the election must be filed with the IRS within 30 days of the date of your restricted stock grant.) 

Below are five steps to ensure your 83(b) election is airtight:

  1. Make three copies of the completed and signed election form and one copy of the IRS cover letter.
  2. Send the original completed and signed election form and cover letter, the copy of the cover letter, and a self-addressed stamped return envelope to the IRS center where you would otherwise file your tax return.
  3. Deliver one copy of the completed election form to your company.
  4. Applicable state law may require that you attach a copy of the completed election form to your state personal income tax return(s) when you file it for the year (assuming you file a state personal income tax return).
  5. Retain one copy of the completed election form for your personal permanent records. 

Given the 30-day election period and required processing steps, it’s critical to discuss the pros and cons of filing the 83(b) election as soon as possible with your financial advisor. They can help you understand how this puzzle piece fits into your overall financial portrait and answer the all-important question: to file or not to file? 

Get Started with Your Founder’s Equity Today 

One of the most consequential personal financial decisions you can make as a founder or early employee of a startup essentially happens at day zero. Speak with an advisor today to make sense of your founder’s stock and whether filing the 83(b) election is the right financial move for you.


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