“to 83b or not to 83b, that is the question” - Hamlet’s accountant
Did you just get offered equity in a hot new startup? Or how about options in your new company that are vesting? You should be thinking about the 83b election!
What do I need to know about the 83b election? - Here’s the TL:DR
The 83b election is only relevant if the equity in question is vesting. If it’s not vesting, the 83b doesn’t apply.
83b election need to be filed within 30 days of receiving the equity, so don’t delay!
When the equity has a nominal value, the 83b is almost always a good idea, but if it’s more material then maybe not.
First, Let’s define a few terms so we’re speaking the same language
Vesting - This means that you “get” the equity, but you don’t really “get” it, because if you leave the company, you forfeit it back to them. This is common for startups to get early employees to stay, but also in larger companies in the form of “golden handcuffs” to keep key employees with the company
Equity - We’re talking about ownership in a company. This may come in the form of common stock for a corporation or ownership units in the case of an LLC. This is not the same as options (see next)
Options - These are the right to buy equity, not the equity itself. They may come with similar vesting requirements, but there are different tax consequences to exercising options and that’s a topic for another time.
83b election - this is a piece of the revenue code, but we’re often using it to talk about a statement that you will mail to the government to indicate that you want to take advantage of it’s benefits. E.g. “forgetting to mail your 83b is an expensive mistake”
Next let’s discuss how do taxes work on equity
Let’s start with a basic idea: Whether you like it or not, when you get “stuff”, the IRS wants to tax it. Often, you get paid with money and its easy to figure out how much is taxable (e.g. if you get paid $1,000, then $1,000 is taxable) but when you get paid with something other than money, the amount you’re taxed on can be a little harder to figure out, particularly if it’s equity in a privately held company that’s just getting started.
Fortunately for you, if you’re going to receive equity as compensation, the company is required to tell you what the fair market value of those shares is at the time they’re given to you. With this, you’re taxed on getting the shares. Seems simple enough, right? well now let’s add vesting into the mix. The IRS might want to tax your stuff, but they agree that if someone has the right to take it away from you, then you haven’t really “gotten” it yet for taxes, and they say you are allowed to pay the tax when you actually get the shares (e.g. when they vest!). That might sound good to pay the tax later rather than sooner, but in the case of a fast growing startup, that presents a real problem: the stock probably isn’t worth much today, but you expect it to be worth a LOT more in the future!
What that means in practice is that if you get 1,000 shares a value of $1 per share, today they’d be a taxable amount of $1,000, but since they’re vesting after 12 months, you have no tax due today. Next year comes and the company raised some capital and the value is now $100 per share when your stock vests. Awesome right? Not so much. When your 1,000 shares vest, you now have taxable income of $100,000 on those same shares! You’ll have a big chunk of tax due, but at the same time, you can’t sell the shares yet because there’s no market. That sucks bigtime.
83b to save the day!
The 83b election is a way to tell the IRS that you want to pretend that the vesting part doesn’t exist for tax purposes. You are electing to pay tax on all the shares now, even though they haven’t vested, but you get to do it at the current fair market value. The upside is that you know how much tax you’re paying and aren’t subject to a random tax bill based on the company increasing in value. The downside is that if you pay the tax now and then later forfeit the shares before they vest, there isn’t a way to get that tax back, its’ gone.
It’s a good idea to 83b when the current value of the shares is very low and there’s an expectation of a huge growth in value over the next few years. This is typical in startups and very new businesses.
It’s not a great idea to 83b when the current value of the shares is more than nominal, and/or the anticipated growth is moderate, but not exponential. This is typical in mid stage companies where the explosive growth has already happened but there’s still more upside potential and they’re offering equity as a way to keep key talent with the company.
To 83b or not to 83b? That is the question. Whether tis smarter for taxes to suffer the the taxable income of outrageous fortune or to take the tax hit now and by filing, end them.