The Importance of 83(b) Elections for Qualified Small Business Stock
Internal Revenue Code (IRC) Section 83(a) states that if property is transferred to a person in connection with the performance of services, the fair market value of the property less the amount (if any) paid for such property is included in the taxpayer's gross income when the property becomes transferable or vests (i.e., no longer subject to a substantial risk of forfeiture). Generally, property is "transferable" when it can be sold, assigned, or pledged to a third party. Treasury Regulation § 1.83-3(d). Transferred property is subject to a "substantial risk of forfeiture" if a person's rights in such property are conditioned on the future performance or nonperformance of substantial services. Treasury Regulation § 1.83-3(c).
For example, if a restricted stock award provides that shares vest over a period of four years and the taxpayer terminates service before such shares have vested – and the taxpayer forfeits the unvested shares – such unvested shares are subject to a "substantial risk of forfeiture." Id. Generally, property is no longer subject to a substantial risk of forfeiture after a specific period of time lapses (i.e., taxpayer must remain employed for four years). At that point in time, such property is said to have "vested."
A taxpayer becomes fully vested in the granted shares after the restrictions lapse. See Treasury Regulation § 1.83-3(b). For substantially vested stock, IRC Section 83(a) requires that any increase in the stock's fair market value between the grant date and vesting date will be treated as taxable wages subject to ordinary income tax rates to the taxpayer for the taxable year in which the restrictions lapse.
How about Section 83(b)?
Under the appropriate circumstances, a taxpayer may elect to recognize income on the value of company restricted stock when granted, rather than upon vesting. This is called a Section 83(b) election and allows taxpayers, including founders, executives, or workers providing services to a company to accelerate the time at which they must include the value of stock in income (i.e., the taxpayer pays ordinary income tax on the difference between the fair market value of the shares on the grant date and the purchase price, if any). By making a timely election, the taxpayer commences her holding period and may be subject to tax at capital gains rates (rather than ordinary income tax rates) after the taxpayer's right to the stock vests and the taxpayer disposes of it.
A Section 83(b) election can potentially provide substantial tax savings when a taxpayer receives shares of company stock subject to vesting. The idea is that assuming the stock increases in value from the grant date to the vesting date, the taxpayer has paid income taxes on a lower stock value. The catch, however, is that if the company's stock at the time of vesting is less valuable or worthless, then the taxpayer has paid more in taxes and is not eligible for a refund or credit.
Example 1: Christopher and Andrew form a legaltech startup, LoveableLawyers, which uses algorithms to help lawyers become more likeable. They form a Delaware C corporation and issue themselves restricted stock that vests in four annual installments based on their continued employment. Andrew, the lawyer, makes a timely Section 83(b) election, reports the current fair market value of the shares to the IRS (later including the difference between the fair market value on the date of grant and the purchase price, if any, as income on his tax return1) and writes out a check to pay for the fair market value of such granted shares. Christopher, the programmer, does not file a Section 83(b) election. Given the great success of their company, Christopher must include in income, subject to ordinary income tax rates, the rapidly increasing value of his LoveableLawyers shares each year as they vest. In contrast, Andrew capped his ordinary income by making the Section 83(b) election and any increase in value in the LoveableLawyers shares is taxed at capital gains rates when he sells the stock in the future.
Another tax savings benefit through Section 1202
IRC Section 1202 provides the statutory basis for the qualified small business stock (QSBS) gain exclusion. In general, IRC Section 1202 allows a shareholder who invests in certain types of startup businesses to exclude up to $10 million of gain or 10 times her basis in the stock, provided the shareholder held such shares for five years. IRC Section 1202(b). Such shareholder must have obtained the stock at original issuance in exchange for money or property (not including stock), or as compensation for services provided to the corporation. IRC Section 1202(c). Additionally, the shareholder must acquire the shares before the company has more than $50 million of "aggregate gross assets." Id.; IRC Section 1202(d). Finally, for substantially all the taxpayer's holding period, the company must use 80% of its assets in a "qualified trade or business." IRC Sections 1202(c) and 1202(e).
To be considered a “qualified trade or business,” the company must meet a number of requirements. First, the exclusion only attaches to shares issued by a C corporation. IRC Section 1202(d). Second, no more than 10% of the value of the company can be composed of real estate or stock and securities. IRC Section 1202(e). Finally, the company cannot be engaged in roughly 20 specific types of businesses, including the performance of services in the fields of health, law, financial services, brokerage services, as well as any banking, insurance, financing, leasing, investing, or similar businesses. Id.
Interplay between the Section 83(b) election and QSBS
Filing a Section 83(b) election starts the clock on the five-year holding period required under IRC Section 1202. Treasury Regulation § 1.83-4(a). So, depending on whether an individual has QSBS subject to vesting, the timing to meet the five-year holding requirement is contingent on whether a Section 83(b) election is made or not.
Example 2: In 2022, after encountering little success with LoveableLawyers, Christopher and Andrew form a Medtech startup company, DoctorsOnLine, which uses algorithms to help Doctors connect electronically with patients. DoctorsOnLine is a Delaware C corporation and Christopher and Andrew issue themselves restricted stock that vests in four annual installments based on their continued employment. Andrew, once again, makes a Section 83(b) election in 2022 and writes out a check for $1,000 to pay for the fair market value of the 1,000 shares of restricted stock granted to him valued at $1.00 per share. Christopher, still having failed to subscribe to the HB Tax Alerts, makes no Section 83(b) election in 2022.
Given that Andrew filed a Section 83(b) election in 2022, his QSBS holding period begins on the date on which the property was transferred as reported on the Section 83(b) election. As such, assuming he holds onto such stock until 2027, the five-year holding requirement for QSBS purposes will be met in that year. On the other hand, given that Christopher did not file a Section 83(b) election, he will have four separate tranches of holding periods for QSBS purposes, beginning each year when his DoctorsOnLine's restricted stock vests. As such, Christopher will have 1/4 of his DoctorsOnLine shares vested in 2023, 1/4 vested in 2024, 1/4 vested in 2025, and 1/4 vested in 2026. Therefore, his four tranches of five-year holding periods will be: 2028, 2029, 2030, and 2031.
The rules for IRC Sections 83(b) and 1202 are complicated, but, as a general rule, founders or early employees who receive restricted stock which may be QSBS should consider filing a Section 83(b) election to start the clock on the QSBS five-year holding period.
 Such income is subject to income and employment tax withholding.
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