Tax Alert – What To Do If You Missed Filing Your 83(b) Election

Guest Post by my partner, TJ Wilkinson:

“Did you file your 83(b)?” 

If the answer is no, and it should have been yes, an array of unwanted consequences may already be in process.  But all hope may not be lost!

The 83(b) election often comes up when a founder or other employee receives stock (or other equity, but I’ll stick with calling it stock) that is subject to vesting – that is, there are conditions that may require the stock to be forfeited, e.g., if the founder or other employee stops working for the company.

The default tax rule for stock subject to vesting is that no income has to be recognized upon grant, but rather will be recognized when the stock vests at the value at the time of vesting.  For example, consider a founder that was issued one million shares of stock with a negligible value at the time of issuance (e.g., $0.0001 per share, not an unusual valuation for an early-stage startup company).  If the company experiences dramatic growth, well, the taxes may be dramatic as well.  In our example, if 25% of the stock vests after one year, when the value is $0.10 per share, then at the end of that year, the founder would owe tax on $25,000 of compensation.  Then, assuming a simple annual vesting schedule for the next three years, the founder would recognize more income every year as the vesting hurdles are met (and if the company is doing what it is supposed to and growing fast, the income will be much greater than $25,000 per year).

Contrast this with what happens if an 83(b) election is made.  If the election is made, instead of applying the default tax rule, the recipient is taxed at the time of grant and at the value at the time of grant.  In our example, the founder would owe tax on $100 (the total value of the stock) at the time of grant, but vesting becomes a non-event for tax purposes (i.e., no additional tax is triggered). 

While the recipient of the stock will probably be the one who is most distraught over missing the election and the resulting tax consequences, it will place a burden on the company as well.  The company will need to decide on a value at every vesting date, and will need to properly report the newly vested stock as compensation.  (On the bright side, the company can generally take a deduction for that amount.)

Particularly for stock in early-stage startup companies that have low valuations, the choice to make the election is a no-brainer.  However, too often it is one of those tasks that is easily overlooked in the excitement and bustle of starting a company or closing on an investment, and there is an inflexible 30-day window in which to notify the IRS of your election. 

I said there was hope, and there is, though there are often collateral consequences to consider.

First, if an employee thinks he is late on his election, make sure the stock was really issued and the 30-day window has passed.  Read the grant agreement carefully – sometimes the grant is conditioned on an event that did not occur (or did not occur until later than intended).  For example, the employee may have had to pay the company a nominal amount for its stock, which he or she never did, or the board was supposed to approve the grant but did not do it on time.  In such a case, it may be possible to take the position that the stock was not actually issued, regardless of what everyone thought, and re-grant as of the current day.  While this will necessitate using the current valuation of the company when the stock is granted, it also starts a new 30-day window for the recipient to file his election.

If the 30-day window is truly in the past, there are still partial fixes if the employee and company are willing to work together.

One simple approach is to amend the grant and have the stock vest immediately.  This causes the recipient to recognize income equal to the current fair market value of the newly vested shares, but no further income would need to be recognized until disposition of the shares.  While this mostly fixes the tax problem, eliminating the vesting changes the business deal, potentially materially. 

A more sophisticated approach takes advantage of the fact that, under the tax law, the stock will be taxable to the employee at the earlier of the time the stock is no longer subject to vesting, or when the employee can transfer the stock to a third party without the vesting restrictions being attached after the transfer.  By amending the arrangement to give the employee such a transfer right, the tax can be accelerated to the time of such amendment and based on the fair market value of the stock at such time, much like if the stock’s vesting was accelerated.   The transfer does not actually have to take place – it is enough that the employee has the right.  Note that as long as the employee is the owner of the stock, the vesting restrictions remain effective.  The company can also add contractual obligations by the employee to discourage the employee from transferring the stock then leaving the company – for example, by requiring the employee to pay a penalty equal to the fair market value of the stock that would have been forfeited if the employee had held on to the stock but left the company before all vesting conditions were met. 

The very best solution is file timely and avoid the problem in the first place, but for those times when that ship has sailed, remember not all hope is lost, and call your tax lawyer.

Meredith S. Campbell
Chair Employment and Labor Group
Co-Chair Corporate Investigations, Governance
 & Risk Management

Email [email protected] T(301)255-0550