05 Nov 83 b Election

83 B Election

The “83 B election” is one of those small tasks that startups (especially closely held companies) need to think about, but which is often also easily forgotten or ignored. The failure to take advantage of the election can be costly: a large tax bill for a shareholder years down the line could be the result.

So what is the election, and when does it usually apply? I’ll try my best to tackle both issues in plain English. Although this topic has been blogged about quite a bit, the issue can be complicated, and explanations can quickly get confusing, so I thought I’d provide a concise summary.

What Is the “83 B Election”?

The election is a tool that accelerates the recognition of income for service providers (i.e., employees) who receive restricted property (often stock) as compensation.

When Does it Usually Apply?

Although it technically applies whenever a service provider receives property as compensation, one of the most common scenarios is when an employee in a close corporation (in other words, a smaller corporation) receives restricted stock at the company’s founding. For example, a startup often will transfer stock to its founders subject to a restricted stock purchase agreement that permits the company to repurchase the unvested stock upon an event, like the shareholder’s firing (shareholders also are often employees in small startups, so the shareholder technically would be fired as an employee). The purpose behind the agreement would be to protect the company by making sure that it gets the stock back if something goes wrong.

Typically, under Section 83, the shareholder wouldn’t recognize income until the vesting of the agreement. Often when agreements vest–this is usually years down the road–the shares are worth more than they were when the shareholder received them at the startup. In these cases, shareholders would be required to pay the difference between the fair market value of the shares and the amount paid. When shares have increased significantly in value, you can imagine the large tax bills that result.

Taking the 83 B election accelerates the recognition of the income to the time of the transfer date. When the stock restrictions later lapse, no additional income results. The election also starts the clock on the shareholder’s stock holding period, which is beneficial from a capital gains perspective. A disadvantage of the election is that, if the stock is later forfeited, no deduction for the amounts previously taken as income is permitted. But the shareholder will still be allowed a loss deduction (usually considered a capital loss) if the amount paid (if any) for the shares exceeds the amount received on forfeiture.

All of that said, the 83 B election is something that should be kept in mind if you’re involved in a close corporation startup. For some nice examples of how the election works, check out The Startup Lawyer blog (a great blog by the way).

Author: Andrew Harris

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