Beyond the Pitch

How Stocks Are Taxed Under 83(a) and 83(b): Why You Should Call Your Tax Advisor

Startups will often use stock to compensate founders, key employees, contractors, and advisors for their services.

The general rule under Section 83(a) of the Internal Revenue Code is that stock given in exchange for services is considered taxable compensation at the time it is received, just as if it were cash. As such, it would be reported on an employee’s W-2 or on Form 1099-Misc for non-employees.

However, stock issued to employees (or advisors) of early-stage companies often has restrictions before the full rights of ownership are transferred (vested). For example, shares could be subject to a vesting schedule causing shares to transfer at the end of each of four years in equal amounts instead of vesting all at once.

When shares are issued with certain restrictions, the shares are not taxable until these restrictions are removed and the holder has the full right to sell or otherwise do as he or she pleases with the shares.

However, when stock is issued with restrictions, the IRS has provided another option under Section 83(b) that is worth consideration.

Election to Include Fair Market Value in Gross Income in Year of Transfer

With the 83(b) election, the employee (or advisor) receiving the shares may elect to be taxed in the current year on the current fair market value of 100 percent of the shares received rather than in subsequent years when the restrictions are removed.

The employee must file the election with the IRS within 30 days of receiving the restricted shares to elect Section 83(b). This is why it is very important to understand the implications of Section 83(b) before you grant or receive restricted shares of stock as compensation.

Tax Basis of Stock at Early Stage May Be Less than When Company Grows

For an employee receiving shares of an early-stage, high growth company, the tax savings from an 83(b) election may be significant. Because the early stage fair market value of shares likely will be at its lowest when the high-growth company is first established, it often makes sense for founders and employees receiving restricted shares to make an 83(b) election in the very early stages of the company.

Another benefit of making the Section 83(b) election is that the 12-month clock for long–term capital gains begins the date when the election is made.

Whether an 83(b) election is made or not, there likely will be additional tax consequences from stock received as compensation. Look at both the total tax liability and the timing of the tax liability when evaluating the 83(b) election.

Consider the following:

  • What is the value of the restricted stock when granted?
  • What is the potential growth in the value of the restricted stock?
  • When will you have the money with which to pay the tax owed? It’s unlikely that you will be able to sell equity that isn’t publically traded to pay the tax liability either when the stock is initially given or as it vests.
  • The 83(b) election creates an immediate tax liability. Based on the current fair market value of the shares received, you must pay the estimated tax liability when the shares are issued.
  • If you do not make the 83(b) election, you will have a tax liability as the restrictions are removed from the shares (i.e. when the shares vest). Based on the estimated future fair value of the shares when they vest, will you have the money to pay the tax owed?

Remember, the 83(b) election must be made within 30 days of receiving the grant of restricted stock. There are no exceptions to this rule.

A sample letter of the 83(b) election and the requirements of the letter can be found at http://www.irs.gov/irb/2012-28_IRB/ar12.html#d0e3012.

The details of each situation will determine whether the 83(b) election should be made or not. Each individual should consult* with his or her tax advisor on this specific consideration before the company is incorporated and stock provisions are set.

*Consult Your Tax Advisor

We are not tax advisors and are not offering tax advice. This discussion is based on current IRS publications. We do recommend that entrepreneurs and startup companies always consult their tax advisor and attorneys on the specifics of their situations, any tax-related matters, or to learn more about the subject discussed in this article.

  • Well stated. It may be worth adding that if the stock vests and is sold at a higher price, that tax then is owed on the gain. That gain is either, per 83(a) the entire sale price, or if an 83(b) election was made then the gain is the difference between the amount elected and the sale price. This article could be read to say an 83(b) election lets you pay taxes only when you acquire the stock, but if you later make a profit selling after vesting then that too is taxed.
    Note: this is not tax advice, and is offered only as commentary on no specific circumstances or investments.

  • Great summary of using stock awards to compensate employees and non-employees. I note that many early-stage companies use stock options instead of actual stock awards. Stock options in early stage companies don’t normally present the taxable income problems and vesting issues that stock awards present, and option awards to employees can be structured as ISO’s which can eliminate ordinary income on exercise by employees if properly-structured. As mentioned by Lee in the comment above, this comment is not tax advance, but is instead offered as commentary on no specific circumstances.

  • Get startup tips and resources delivered directly to your inbox.

  • Resources

    Getting Started
    Tips for turning a concept into a company

    Getting Customers
    From honing your pitch to getting your first customer

    Success Stories
    Entrepreneur Success

    Getting Funding
    How and where to get the cash you need to grow

    The Hard Stuff
    How to navigate hiring, taxes, legal and more

    The Network Effect
    Making the right connections at the right time

    #Startup Buzz
    The news and trends that matter to you

    Rev1 News & Events
    The latest buzz and networking opportunities