Venture Best

By: Melissa M. Turczyn

Key employees of start-up companies will typically hold their shares of common stock in the form of restricted stock, subject to certain vesting criteria. In essence, this means that a set number of shares will vest upon the happening of future events, lengthening the amount of time it takes for the employees to have full ownership of their shares in the company. Investors often require this type of arrangement, as it provides a continuing incentive to make the company successful.

Under certain tax laws, shares which are not fully vested will be treated as having a substantial risk of forfeiture, meaning the employee’s rights in the stock are conditioned upon one or more future events. If an employee leaves the company for any reason, prior to the time all shares of his stock vest, the employee will forfeit any rights he has to the unvested shares. As a result of this possibility, the IRS does not tax the employee upon the initial issuance of the restricted shares. More specifically, the employee will not pay tax until the restricted shares actually vest, at which point the employee will pay tax on the fair market value of the stock at that time. While this delay in paying taxes may seem like a good outcome, in actuality, it can cost the employee a lot more money down the road.

Presumably, the employee believes the company is going to be wildly successful in the near to mid future. If that is the case, the company is going to be worth multiples of what it was worth when the restricted shares were actually issued. This increase in the valuation of the company is going to lead to an increase in the amount of tax the employee will pay, once his shares actually vest. So the IRS gives the employee the option to pay his taxes early, when the stock will likely have a lower valuation, by filing a tax election referred to as an “83(b) election”. In addition, if the employee elects to file an 83(b) election, the capital gains period will start on the date the restricted shares are issued, as opposed to the date the stock vests, giving the employee a jump start on the one-year holding period for long term capital gains treatment.

To take advantage of this opportunity, the employee must submit an 83(b) election to the IRS within thirty days of the date of issuance of the restricted shares of stock. There does not appear to be any extension allowed for this time period, so it is imperative that the employee submit his election within the first thirty days. The election is made by submitting one copy of a written statement to the specific internal revenue office with which the employee files his individual income tax returns. Copies of the election will also need to be submitted (i) with the employee’s income tax return for the taxable year in which the shares are issued, and (ii) to the company.

Taking into account all of the above, what is the downside of filing an 83(b) election? First, such an election is not revocable (with very limited exceptions). So if the vesting criteria are not satisfied, the employee will likely have paid a higher amount of taxes than he would have otherwise paid. If this happens, the employee is unable to revoke the election or receive a refund from the IRS. Additionally, if the valuation of the company actually decreases before an employee’s shares have fully vested, he will likely have paid a higher amount of taxes. Again, he can not revoke the election or request a refund. In most cases, however, these risks are not strong enough to defer an entrepreneur from having full faith in his company, and in making the 83(b) election.