Section 83(b) Election
Posted on Dec 1, 2021 4:15am PST
The Internal Revenue Code allows employees, or startup founders, the option
to pay an income tax on the total value of the restricted shares (equity)
received at the grant date.To effect this taxable event, the recipient
of the shares must make an election with the IRS within 30 days of the grant.
Why would any recipient elect to pay taxes, and not defer them?The answer
is in the details.Normally, grantees of restricted shares are not taxed
until the end of the vesting period.In essence, the shareholder is betting
that, at the time of the grant, these shares are at a very low value.Thus,
the tax is minimal.And, the assumption is that those shares will be much
more valuable in the future.
The shareholder only “loses” if the value of the company continually
declines or a liquidation occurs.The IRS does not allow an overpayment
claim for worthless stock.If the company value grows during the vesting
period, it will not impact the recipient.He has fulfilled his tax obligation.He
will not pay any tax as he vests, and gets to keeps his vested shares.If
shares are sold in later years, this employee/co-founder is subject to
capital gains tax on the proceeds.
The question remains:how does the company justify the valuation of a restricted
share?Most professional advisors recommend a thorough, independent valuation,
and not the use of book value.Obviously, the further out the growth in
cash flow occurs, the less present value in the company.Still, this valuation
is subject to IRS scrutiny or audit, so it must be supportable.
We recommend that the initial valuation be updated yearly.First, those
with vesting shares will understand how their performance has impacted
the firm’s value.Second, later rounds of investors will be encouraged
by the firm’s increase in value.