Risks of Not Filing an 83(b) Election for Startups
Equity pay may be a tricky landscape for entrepreneurs and workers to navigate in the fast-paced world of startups. The 83(b) election is one of the most important yet frequently disregarded parts. By allowing individuals to defer paying taxes on the appreciation in the value of their equity until it vests, rather than paying taxes on the fair market value at the time of grant, this decision can save individuals significant sums of money.
Let us explore the potential consequences of skipping the 83(b) election for new businesses, explaining why this seemingly insignificant administrative process might have far-reaching effects on your long-term financial security.
Filing an 83(b) election requires careful consideration but can result in substantial tax savings and maximize the benefits of equity ownership for startup employees.
Understanding the 83(b) Election
Let’s have a firm handle on the fundamentals of the 83(b) election before diving into the potential dangers. There is usually a vesting time involved when an employee is granted restricted stock or stock options by their company. There are conditions attached to the equity award throughout this time, such as a minimum number of service years or the completion of particular objectives.
Understanding the importance of the 83(b) election and seeking professional advice can help startup employees make informed decisions and optimize their tax planning strategies.
By making a special election under Section 83(b) of the Internal Revenue Code, the receiver of restricted stock or an option may choose to pay tax on the full value of the equity at the time of grant rather than having to wait until the stock or option vests. This creates a new cost basis for the stock, which the receiver might use to negotiate favorable tax treatment of capital gains when the stock is sold at a later date.
The Risks of Not Filing
If a shareholder fails to make an 83(b) election before the deadline, the stockholder and the issuing business may still be able to take steps to limit the financial impact of this failure. We’ve laid out your three choices below. If a long period has gone since the stock was issued and some of the unvested stock has already been vested, there may be outstanding tax liabilities on the part of both the company and the employee. Here are some of the risks discussed.
Startup founders and employees should be aware of the risks associated with not filing an 83(b) election, as it can result in higher tax liabilities and the potential loss of equity value.
Tax Consequences
Not making an 83(b) election carries the danger of paying more in taxes down the line. If people do not choose to pay taxes on the value of their equity when it is granted, they may be liable to regular income tax rates when the equity vests. The tax burden might be large if the value has increased considerably throughout the vesting period. Capital gains treatment is available upon timely filing of the 83(b) election, which may result in substantial tax savings in the future.
Cash Flow Concerns
When cash flow is tight, it can be difficult for a startup to recruit and keep top employees without offering some kind of stock compensation. Individuals may get into trouble if they don’t make an 83(b) election. Even if they haven’t yet sold the stock or received any cash from it, they will still be required to pay taxes on the full value of the stock when it vests and the corresponding tax liability occurs. For some people, this may put undue pressure on their money and lead to cash flow problems.
Loss of Equity
If an employee does not make the 83(b) election and then departs the firm before the stock completely vests, the employee runs the risk of losing the equity. The individual will be liable to ordinary income tax rates on any appreciation upon vesting or sale if the election is not made since no new cost basis will have been formed for the equity. The equity’s value and prospective earnings may both suffer as a result.
Example of a situation if the 83(b) Election is not filed
In this scenario, a startup founder is granted one million shares that vest over four years. If the founder files an 83(b) election, they would be required to pay ordinary income tax on the fair market value of all one million shares at the time of grant. However, if the founder fails to file the election, the tax implications can be severe.
Let’s consider the valuation of the shares over time: $0.05 at grant, $0.50 after the first year, $1 after the second year, $3 after the third year, and $4 after the fourth year. Assuming a 35 percent ordinary income tax rate, the consequences become evident.
If the founder files the 83(b) election, they would owe $17,500 in ordinary income tax ($50,000 x 35%) based on the initial share valuation. However, without filing the election, the tax consequences escalate dramatically. As the shares vest over four years, the founder would need to recognize the increasing fair market value as income on each vesting date.
In this example, the founder would end up owing a staggering $743,750 in ordinary income tax on the receipt of the shares. The total taxable income amounts to $2,125,000 ($125,000 + $250,000 + $750,000 + $1,000,000), subject to the 35 percent tax rate.
Filing 83(b) Election with Eqvista
Filing an 83(b) election is crucial for startup employees. Our knowledgeable and certified experts will guide you through the entire filing process, offering support, guidance, and assistance. With Eqvista, you can eliminate the stress and difficulties associated with filing an 83(b) election. Our 83(b) Election filing service starts at $150, which includes consultation and form filing by our expert team. Schedule an appointment with us today and ensure your financial well-being as a startup employee.
