No matter how an Idaho or California company decides to issue founders stock, it is important to keep tax considerations in mind. A founder who receives stock subject to forfeiture is at risk of the incurring higher taxes on the stock as it vests. For restricted stock (the type of stock generally issued to founders), a founder has to pay tax every time shares vest (remember, this is generally a monthly vesting schedule with a 1 year cliff). The tax owed by the founder in this case would be the difference between the current value of the stock and the price initially paid. This can feel as if the founder is being penalized by higher taxes for the value of the company increasing. And, in the case of a normal startup that does not have liquid stock, the founder cannot then sell shares to offset the tax burden. The IRS does not consider that the founder is not realizing any gain from their equity, it treats liquid and non-liquid stocks the same.
However, this can easily be solved using something called an “83(b) election”. Essentially an 83(b) election allows the founder to pay all the tax up front when the initial stock is received. The 83(b) election is typically a one-page document the founder can send to the IRS within 30 days of receiving property. This document informs the IRS that the founder would prefer to be taxed for the property which is subject to a “substantial risk of forfeiture” now rather than when it vests. If the founder files an 83(b) election, before the value of the company grows, the founder will only pay taxes on the current value of the stock (generally less than 1 cent per share). Because the value of the company has not increased and the founder paid less than one penny per share, the tax is effectively zero.
If a founder does not timely file an 83(b) election, he/she will be taxed at the fair market value of the stock only when it is vested. That means if the company continues to increase in value, the founder will continue to be taxed at higher and higher rates as the stock vests. The vested stock will be treated as compensation income and will be subject to ordinary income tax and applicable income and employment tax withholding.
On top of the financial benefit of the 83(b) election, not filing an 83(b) election can cause the founder and company additional administrative headaches. For example, the company would have to determine the value of the shares at each vesting date in order to report the value and comply with tax withholding requirements. By filing an 83(b) election, the founder and the company avoid extra challenges and payments.
An 83(b) election might not make sense for you and your company if you expect the value of the shares to decrease rather than increase or if you plan on leaving the company before the shares vest.
