What is an 83 (b) tax election and why it is important for startup founders?
This article is relevant for startups who have issued restricted stock to the startup founders.
Section 83 b defined in simple terms
Section 83 b applies if the founders received restricted stock. In most cases and best practices, founders restricted stock package spans to four years with one year cliff. In simple terms, on the first year anniversary 25 % is vested, another 25% on the 2nd year anniversary etc. If the founder leaves the company before the first year, he does not earn any stock.
Why is section 83 b so important?
It is a letter that you send to the Internal revenue service within 30 days of the grant date. It notifies the Internal revenue service to tax the shares of the restricted stock on the official grant date instead of the vesting date. This, in turn, brings in tax savings. It accelerates the calculation of the ordinary income. It is advantageous as the income is taxed in the early stages rather than when the stock has a higher value at a later date.
How soon you need to file section 83 (b)
Section 83 (b) must be filed with the Internal revenue service within 30 days after the official stock grant date.
Example of how 83 (b) tax election benefits founders
Assuming 10,000 restricted stock were granted with a value of $0.01 per share.
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With 83 (b) Tax election
Ordinary tax ( year of stock grant): You will pay $39.6 as tax (assuming 39.6% tax bracket – 10,000*39.6%).
Sale of stock after one year: Assume $10 per share as the sale price.
Your taxable gain will be $10-0.01=$9.99 per share as you already included $0.01 earlier.
The total taxable gain will be $9.99*10,000=$99,900
Taxable tax @ capital gains rate of 20% will be $19,980
Economic gain after tax will be $100,000 ($10,000*10) minus $39.6 minus $19980 = $79,980.4
2. Without 83 (b) tax election
Assuming the shares vested in one year and the value of each share has increased from $0.01 to $ 1 at one year anniversary, the following would be the calculation :
One year vesting date : $1 * $10,000 = $10,000 * 39.6%= $3960 tax
After a second year these shares were sold at $10 per share :
Taxable gain is calculated as follows $9 per share * 10,000 = $90,000
Taxable tax $18,000 ( $90,000 * Long-term capital gains rate of 20%)
Economic gains after tax will now be $100,000 minus $3960 minus $18000 = $78,040
Therefore, filing an 83 b tax election has saved $1,940.4
The above is a simple example, contact a tax professional for more detailed analysis based on your situation.