united-states, taxes, equity, 83bI’ve been doing a fair amount of research, trying to get opinions from different sources. As a startup co-founder, one of my goals has been to play my taxes legally and ethically, but also responsibly.
Playing the “tax game” is clearly something that can determine how much money we pay in early stages, when we get bought out, etc., therefore I believe it is valuable to consider if and when I should write this letter to the IRS (I am American).
I understand that the letter must be written in 30 days, and I understand what it is, essentially (the ability to pay taxes par value at present date, rather than the taxes of the shares when we sell out). For those who don’t know, they are described here.
However, my best business adviser (has sold companies for personal gains upwards of $50m) recommended we stay away from the 83(b) election for the sake of making trades and seeing big drops in stock prices, and still having to pay the tax based on the old, higher share price.
After reading, it seems like it’s always a good thing (but my adviser clearly advised against this). I think a good answer to this question would adequately list when a business would consciously make the decision not to enroll and why they chose not to enroll.
In short, and to make sure I don’t get opinionated responses, can we limit this to factual relationships between scenarios where a business would and would not enroll in the 83(b) election.
The article to which you have linked sums up the pros and cons quite well, giving examples of situations in which making an election might be wise and unwise. If the stock rises in value between being granted and vesting (and assuming your marginal rate of income tax does not change in the interim), you’ll pay less nominal tax by making an election; if it falls in value, you’ll pay less nominal tax by not making an election.
Of course, nominal tax is only one part of the story: you also need to finance the assessed tax, and money has a time-value. In general, it is worth settling future liabilities based on present values if and only if:
you have cash available to pay today’s settlement; and
the liability is expected to grow faster than the (net) return you would receive for investing that cash elsewhere.
The income tax liability will grow at the same rate as the stock’s value (and therefore the question is whether you can grow cash faster than your stock—given that one way of investing your cash could be to buy further stock, this may not be all that unlikely). The growth in capital gains liability is more complicated, as it depends not only on the rate at which the stock rises in value but also on the vesting schedule.
If the grant has negligible value (as will be the case with most startups), then the required cash is minimal (and so too would be any investment returns). In such a case, you pretty much have nothing to lose by immediately settling the future tax liability (at almost nil value).
However, if the grant has some non-negligible value, the time-value of money can have quite a significant effect. There are too many variables to give a generic answer, as one would need to compare the difference between cash investment return and stock growth rate with the capital gains benefit that would be derived from the vesting schedule.
If the stock is nearly worthless today, then taxpayers should usually elect. If there is a very real risk that the valuable stock will not vest, or that the stock will be worth less at vesting than at the time of election, then the 83(b) election can be riskier.
The §83(b) Election. First, the business itself is not making the election - the recipient is. The recipient taxpayer waives the uncertainty that the granted property will be forfeit and invites taxation now rather than at vesting. The election is irrevocable, so the game is playing with rates (trying to get capital gains rather than ordinary income) and estimating whether the property will be worth less at vesting than at election. The time value of money may be a significant factor.
Elect. In situations where the stock has little or no value, the election is almost costless and so should generally be made. The tax, if any, is paid on the grant today. When the taxpayer sells the equity, the gains are capital and so taxed at a lower rate.
Don’t Elect. In situations where the stock has significant value at granting, the election is much more questionable. Electing a significant stock grant means major ordinary income today and tax on next year’s taxes - perhaps without much liquidity to pay those taxes. If the stock actually vests a year or two later, then the hope is that it had a meaningful appreciation in value so that some of the ordinary income was moved to capital gain. If there was only a small gain, or even a loss, then the election was detrimental - the taxpayer paid taxes a year or two early (lost time value of money) and didn’t save on tax in the later years sufficient to make up for that.
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