Seraf Toolbox: Dealing with Restricted Stock - Model IRS 83(b) Election Form

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Sample IRS 83b Election Form
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Many years ago I joined the board of a company after my angel group became the lead investor in the company’s seed financing round. As part of my compensation for being a board member, the company issued me restricted stock. Since I was new to the early stage investing world, I didn’t understand what the tax implications were with restricted stock. It’s unfortunate that I didn’t get good tax planning advice at the time, because if I had, it would have saved me a significant amount on my tax bill when the company was acquired for a very significant price!

Fortunately, you don’t have to make the same mistake I did. To help you avoid my fate, let’s get started and provide you with some critical planning advice to help you put better plans in place. After you read this article, you should have a basic understanding of the following items:

  • What is Restricted Stock?

  • What is an IRS Section 83(b) Election?

  • What do I need to do to file an 83(b) Election?

  • What are the tax implications when you file an 83(b) Election?

Restricted Stock is given to employees, directors and advisors of early stage companies as a form of compensation. It’s called restricted stock because your ownership rights are imperfect or restricted. There may be vesting conditions which need to lapse or there may be “restrictions” on when the shareholder is able to sell this stock. Most restricted stock grants require that the shareholder be active with the company for a certain number of years in order to fully own all of the restricted stock.

Download the Sample IRS Section 83(b) Election Form >>

An IRS Section 83(b) Election is an approach to minimizing the amount of tax you will pay as you vest your stock. What you are basically doing is opting to pay taxes earlier than you have to (1) to lock in a low value at that time and (2) in exchange for a better rate later on. In effect, you declare ownership early, and pay ordinary income taxes on your ownership when the stock is less valuable and then later pay the lower capital gains tax rate on the increase in value.  

How does this work? In the early days of a startup company, the fair market value of the stock is pretty low because the company isn’t worth that much. Over time, the stock becomes more valuable as the company grows its revenues and builds value for its shareholders. Since restricted stock is treated as income by the IRS, it’s best to recognize that income on your taxes when the company’s stock is at a low value. Filing an 83(b) Election is allowing you to recognize, by approval of the IRS, the value of the restricted stock at the date of the election versus later as the stock vests.

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Filing an 83(b) Election is not that complicated, but it does require a fair number of steps and it must be done in a very timely fashion. The first thing to be aware of is you must file your 83(b) Election within 30 days of receiving the grant. That’s not much time to get your paperwork filed, but those are the rules! Now, here are all the steps you must take to make a proper election…

  • Start by downloading a Sample IRS Section 83(b) Election Form.  There are a few items you will need to know to fill out the form, including the fair market value price of the shares you are receiving and the total amount of income that will be added to your gross income.

  • If you download this sample form, you will also notice a sample cover letter that you should fill out and include when you mail your 83(b) Election Form.

  • Once you complete the 83(b) Election Form and the cover letter, you should mail them to the IRS Service Center where you typically file your federal income taxes. If you are a stickler about keeping tidy records, you can send your mail by certified mail and request a return receipt. And, make sure you send these documents within 30 days of receiving the grant!

  • The final item on your task list is to mail a copy of the 83(b) Election Form to the company for their financial records.

It’s also important that you understand the tax implications when you file an 83(b) Election. There are three types of tax rates you need to be aware of to understand how filing an 83(b) will affect the amount of tax you ultimately pay out.

  • Ordinary Income Tax Rate: For high income individuals (which I assume includes most people who end up receiving restricted stock!), this tax rate is the highest rate you will pay. In 2016, the maximum rate was set at 39.6%.

  • Short Term Capital Gains Tax Rate: If you sell your stock after holding it for less than one full year, you will pay taxes at the Short Term Rate. In 2016, your Short Term Rate was the same as your Ordinary Income Tax Rate.

  • Long Term Capital Gains Tax Rate: If you sell your stock after holding it for more than one full year, you will pay taxes at the Long Term Rate. In 2016, the Long Term Rate was 20%.

One goal of filing an 83(b) Election is to limit the amount of taxes you pay while your stock is vesting. To illustrate how an 83(b) Election works for your taxes, let’s walk through a very simple example.

  • You receive a grant of 100,000 shares that are valued at $0.05 per share at the time of the grant. If you file an 83(b) Election within 30 days of this grant, you will need to include $5,000 of income on your taxes for that year. If you are in the highest tax bracket (39.6%), you will pay $1,980 in Federal Taxes.

Now, let’s say you don’t file an 83(b) Election. In this case, you will pay taxes over a four year period as follows.

  • To keep this example as simple as possible, I will assume that your stock vests at a rate of 25% each year. So every year, you vest 25,000 shares. And, again to keep this simple, I will assume that the stock appreciates in value each year by $0.05 per share. That’s a conservative assumption for a company that’s doing reasonably well and showing solid growth.

  • At the end of year one, you vest 25,000 shares and the price of those shares is $0.10 at the time of vesting. Your income for the year is $2,500 and you pay $990 in Federal Taxes (39.6% of $2,500).

  • At the end of year two, three and four, you vest 25,000 shares each year. The price of the shares is $0.15 at year two, $0.20 at year three and $0.25 at year four. Your income for each of those years is $3,750, $5,000 and $6,250. And finally, your Federal tax payments are $1,485, $1,980 and $2,475.

  • All told, you will pay $6,930 in Federal Taxes during the four year vesting period.

In this example, by filing an 83(b) Election, you saved $4,950 on your Federal Tax bill. Not a bad savings for a few minutes of work!

There’s one other potential large tax savings if you file an 83(b). That savings relates to a reduction of the Long Term Capital Gains tax you pay when holding stock for more than five years. This significant tax reduction is described in IRS Section 1202 of the US Federal Tax Code.

It’s possible to pay no Long Term Capital Gains on your Federal tax return for stock held more than five years. By paying taxes on your restricted stock when you first receive the grant, you start the clock ticking on the five year holding period right away. If you wait to pay taxes on the stock at each year of vesting, you push out the five year holding period. So, for example, if the company is acquired 6 years after your initial restricted stock grant, you will pay no Federal capital gains on that stock if you filed an 83(b). If you didn’t file an 83(b), you will pay Federal capital gains tax on the stock you vested in years 2, 3 and 4. And, that could be a BIG tax hit!!

Beware of the one downside to the 83(b) Election. If the company goes out of business a year or so after you file your 83(b), you will have paid taxes on value you will never receive, and you can’t get those tax payments refunded.

Since taxes can be quite complicated, you should talk to your financial advisor / accountant to make sure you are doing the right thing given your personal financial situation. To learn more on restricted stock, read Pure Upside: Understanding Stock Options and Restricted Stock for Angels.

 

Download the Sample IRS Section 83(b) Election Form >>

 

For a more in-depth discussion on early stage company board issues, download our companion eBook: Director’s Guidebook: How to be an Effective Board Director in Early Stage Companies or purchase our books at Amazon.com

To access additional resources and download more templates, view our entire Director’s Guidebook Series.