An 83(b) election, codified in 26 United States Code § 83, has the potential to provide founders, executives, or one providing a service to a company, with tax savings when they receive shares of stock subject to vesting in that company. This election alerts the Internal Revenue Service to tax the individual making the election on the total fair market value of the stock at the time of granting rather than at the time the stock vests. Should the stock increase in value during the applicable vesting period, an individual has already paid the income taxes on the lower value of the stock. However, if the stock becomes worthless, the individual has potentially overpaid in taxes. This is the risk one takes when deciding to utilize an 83(b) election and should be discussed carefully with legal counsel and tax advisors. For many startup founders, where the value of the company at formation may be very little, 83(b) elections are often utilized.
Internal Revenue Code § 1202(A) provides another tax savings benefit, allowing a shareholder to exclude from federal income tax liabilities a certain amount of capital gains recognized from the sale of Qualified Small Business Stock ("QSBS"). A shareholder may exclude from his or her gain the greater of $10 million or 10 times the holder’s cost basis in that stock. The shareholder must have obtained the stock when it was originally issued in exchange for money or property (not including stock), or as compensation for services provided to the corporation.
Only certain companies meet the requirements of a Qualified Small Business (“QSB”) and can issue QSBS. According to United States Code (“U.S.C.”) § 1202 a business is considered a QSB if it is a C corporation with assets totaling $50 million or less at all times after the date of the enactment of the Revenue Reconciliation Act of 1993 (August 10, 1993) and before and immediately after the issuance of the stock. The business must also meet the active business condition requiring “at least 80 percent (by value) of the assets of the corporation are used by the corporation in the active conduct of 1 or more qualified trades or businesses…” For the purposes of this requirement 26 U.S.C § 1202(e)(3)(A)-(E) states, “qualified trade or business means any trade or business other than (A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal assets of such trade or business is the reputation or skill of 1 or more of its employees; (B) any banking, insurance, financing, leasing, investing, or similar business, (C) any farming business; (D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A; and (E) any business of operating a hotel, motel, restaurant, or similar business.”
A question remains regarding the interplay between these two tax saving strategies. When utilizing 26 U.S.C. § 1202(A) for QSBS after receiving restricted stock does filing an 83(b) election provide any additional benefit to the taxpayer? Often times tax advisors will take the position that utilizing QSBS eliminates the need to utilize an 83(b) election.
This, however, misses one important point worth considering where shares are subject to a vesting schedule.
Filing an 83(b) election will start the clock on the five-year holding period required under 26 U.S.C. § 1202. To even qualify under § 1202, a shareholder must have held the specific QSBS for five years. Should an individual have QSBS subject to vesting, the total amount of time before all stock reaches the five-year holding requirement differs depending on whether one utilizes an 83(b) election or not. For an example of how this may work, please see here. For instance, if shares are subject to a four-year vesting schedule with a one year cliff (as is typical with high-growth ventures), the five-year holding requirement will not even begin until after the one-year cliff and thereafter alongside the remaining shares that vest pro-rata over the remaining three years.
If you have received QSBS and potentially plan to sell that QSBS in the future (perhaps through an exit or M&A transaction), it may be beneficial to make an election under 26 U.S.C. § 83(b) on the stock received to start the clock on the five-year holding period. TO do this, an 83(b) election must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. If you fail to meet the 30-day requirement, the election will be void. Contact a legal or tax advisor for assistance with determining whether you qualify.
The information provided in this post does not, and is not intended to, constitute legal advice. In accordance with the U.S. Treasury Regulations contained in IRS Circular 230, please be aware that any U.S. Federal tax advice contained in this post is not intended to be used and may not be used, for the purpose of avoiding U.S. Federal tax penalties or for the purpose of promoting, marketing or recommending any entity investment plan or transaction