83(b) Tax Elections

83(b) of the Internal Revenue Code is a niche tax-savings allowance for entrepreneurs and the tech geeks they hire (not the technical definition).

83(b) implicates the following: if you're a founder, an early employee or otherwise a recipient of RESTRICTED EQUITY ("equity" = stock or LLC units, etc. but NOT options (which aren't recognized as property by the IRS until exercise (but note that some options plans allow for early (prior to vesting) exercise and these options would be "restricted")); "restricted" = restrictions that lapse, typically due to vesting) in a start-up, then, presuming you'd rather pay less taxes than more, you should notify the IRS IMMEDIATELY upon receiving such equity (by filing an 83(b) notice).FN1

According to 83(b), if you voluntarily and timely (the 30 day(!) deadline is notoriously inflexible) notify the IRS that you've received such restricted equity, then you assume immediate income tax liability on the difference between the FMV of that equity (usually not much about zero (i.e., par value) in the inception stage of a start-up corporationFN2) and the amount you paid for that equity (usually par value or zero, as negotiated). At the future date when you later sell that equity, then you pay capital gains tax on the appreciation from the original date of purchase.FN3

If you fail to make that initial notification, you are taxed instead at each future vesting milestone (typically, at the year cliff and then monthly/annually for the next three years). This may have significant implications. For example:

Joe Founder is granted company stock at some nominal purchase (probably par value) price (say $0.01 per share) with a FMV of $0.001 per share. The stock has four year vesting with a one year cliff. Joe doesn't file an 83(b) election. At the end of the one year cliff, the stock having appreciated to $1.00/share, Joe recognizes and must taxes on $0.999/share of income for that year. As the remaining stock subsequently vests each year/month (whatever each vesting milestone is), Joe again recognizes and must pay ordinary income taxes on "income" (even though the stock is presumably illiquid and Joe can't sell it) equal to the difference between the (presumably rising) FMV of the newly vested portion and the original $0.001/share purchase price. Moreover, the company is required to pay the employer’s share of FICA tax on the income and to withhold federal, state and local income tax.
If Joe had made an 83(b) election, he would not recognize any income as the stock vests, because the 83(b) election forever freezes the income calculation as of the original grant date.

It almost always makes financial sense to file the 83(b), however, it does depend on the underlying value of the equity at the time of issuance and future prospects. In the odd circumstance that the equity at the time of grant has a material FMV AND there is a material risk that it won't increase in value (because, say, the start-up fails), you've accelerated your tax liability without receiving any benefit.

FN1. The mechanics of filing the 83(B) notice are surprisingly informal. While forms exist to facilitate the process, none are issued or required by the IRS. A handwritten note sent to your local IRS office (the full list of information that needs to be provided can be found here) would technically suffice. What really counts is the 30 day filing period. There is no extension available, or any simple cure for missing the deadline.

FN2. Note that Companies (via the Articles of Incorporation) typically assign a "par value" to stock (in some states its a requirement), which prohibits the Company from issuing stock to anyone at a price below that par value (i.e., no free stock).

FN3. The default Section 83 rule is that income (the difference between FMV and the price paid) on restricted stock is not recognized until the restrictions lapse. This rule is actually intended to benefit the taxpayer - the unique economics of start-ups undermine the intention.