When founding an early-stage startup company, it is essential to consider who owns what portion of the company; this is known as equity allocation. While employees and founders receive their startup shares, they must pay taxes when those shares vest, meaning they are granted full rights to the shares. At this point, the value of those shares may have significantly increased, so both employees and founders must pay their applicable tax rate on them.
However, there is a strategy to lessen the tax burden by paying taxes earlier in the process when the shares are initially granted. This could potentially reduce taxable income significantly and provide substantial savings.
What Is An 83(b) Election?
An 83(b) election is a tax election that allows an employee or founder to pay taxes on stock options or restricted stock upfront rather than paying taxes on any future gains or vesting periods. Essentially, it allows the recipient of the equity to recognize the income at the time of the grant or purchase rather than when the equity vests or is sold much later when the price could be substantially higher.
Why Is It Important To File For An 83(b) Election For Startup Employees And Founders?
For startup employees and founders, an 83(b) election can be particularly beneficial for their finances. Typically, early-stage startup employees receive equity in stock options or restricted stock, which may be worth little when initially granted, especially if they are early-stage startup employees.
However, as early-stage companies grow and become more valuable, the valuation and, thus, the equity may become significantly more valuable. By making an 83(b) election, the employee or founder can pay taxes upfront based on the current equity value rather than paying taxes on future gains, potentially resulting in significant tax savings for them.
How To File For an 83(b) Election?
To make an 83(b) election, an employee or founder must file a written statement with the Internal Revenue Service (IRS) within 30 days of receiving the equity grant or purchase. The notice must include specific information about the equity, such as the date it was granted or purchased, the fair market value, and the amount of income recognized.
What Are The Pros And Cons For 83(b)?
It is important to note that making an 83(b) election could only sometimes be the right choice for everyone. Paying taxes on stock upfront can have some downsides for both founders and employees:
1. Filing an 83(b) election requires paying taxes upfront, meaning that if the startup fails, the stock value declines over time, or you leave the startup, you may incur a loss.
2. Once an 83(b) election is filed, there is no opportunity to receive a refund, even if the stock value declines or the employee or founder leaves the company.
3. An 83(b) election requires strict compliance with specific IRS requirements, including filing the election within 30 days of the grant or purchase. Failure to comply with these requirements can result in significant penalties and legal issues.
In conclusion, an 83(b) election can provide significant tax savings for startup employees and founders. However, it is essential to fully understand the potential implications and risks before choosing an 83b election. We recommend consulting with a tax advisor or attorney and performing your own due diligence to determine the best decision.
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