As I’ve written about in the past, founders of a startup should have their equity vested. There are times when you may not want to, but the majority of the time it is beneficial. Some investors may insist upon it, although its one of the things in the negotiations. If the founder’s stock is vested, they should make an 83-b election. To not do so could turn into a lot of tax due to the IRS over the years the stock will vest. We’ll discuss how it works and how to make the election here.
Now a lot of the way things are done in corporate law is based on tax consequences. When you form a startup corporation and issue the founders their stock on day one, the certificate of incorporation usually sets the par value of the shares very low, usually $.001-$.0001. If a founder is getting 300,000 shares that have par value of $.001, then he will pay $300 for the shares. The founder should also always sign an assignment form assigning all of his IP to the corporation at that time, and the IP (or past services) can be used to fulfill the $300 that the founder needs to pay. Its usually best that he pay and sign the assignment. Past services aren’t the way to go as there can be tax consequences, that aren’t there for a cash and IP “payment.” If the founder pays for the shares and receives them all on day one with no vesting restrictions (so no repurchase right held by the corporation), there will be no tax consequences.
If however the founder pays for the shares on day one, and the shares are vested, and the founder does not make a timely Section 83-b election with the IRS, then the founder will be liable for the increase in value of the shares that he receives each year. So in our example if the founder receives 25% of the shares after a one year cliff, the shares will likely be worth much more than the low par value. The founder would have to include the value of the shares he received as income for that year. And the same goes for the next couple years until all of the shares have vested. As successful startup companies increase in value very quickly, failure to make an 83-b election can add up to a lot of “income” that a founder may owe taxes on – when he or she wouldn’t even have the actual cash to pay.
When an 83-b election is made, the founder is electing to have the tax consequences of receiving all of the stock in the year of the election. Because paying cash or assigning IP for the shares will not have a tax consequence, the founder will enjoy the increase in the stock that vests each year tax free.
When a founder signs the agreements with the corporation to receive the initial founder stock, that founder has thirty days to submit a completed 83b election form to the IRS office where the stockholder sends his/her tax returns each year. The election form should usually be sent Certified Mail, return receipt requested to ensure the IRS receives it in a timely manner. The founder should keep a copy of it and give it to the Company as evidence after its mailed in. Then when the founder completes his or her tax returns for the year they receive the stock, they need to attach a copy of the form with the returns when they send to the IRS.