Taxation of Founder Stock & The 83(b) Election

In Previous Article, we saw how Section 83 of the Tax Code operated under different circumstances, and how an entrepreneur or founder could utilize the election provisions of Section 83(b) to lock-in the taxable value of equity. In this article we’ll plug in numbers to see how this election affects a founder’s sale of stock upon his/her departure from a company.

Let’s start with a basic fact pattern. The founder and his/her investor make the following deal: founder contributes his ideas and work to the business, and investor contributes $1M. Each get 100 shares, and both accordingly own 50% of the company.

Now let’s fast forward five years. The founder is ready to leave the company, and perhaps to start a new one. He prepares to sell all of his 100 shares in the company, all of which have just become fully vested. The shares are worth $1M. Let’s examine the possible tax consequences of this transaction.

For the first example, let’s assume that the founder did not make a Section 83(b) election. Under these facts, the founder recognizes $1M of ordinary income under Section 83(a), roughly $350K. The stock was subject to vesting, and its value is taxable when it becomes fully vested. Thus, assuming the founder sells the shares on the same day they become fully vested, ALL of founder’s appreciation in the equity is taxable as ordinary income under Section 83(a). This is obviously a terrible result for the founder, who would much rather receive long term capital gain (LTCG) treatment upon the sale of his/her shares.

As a second example, let’s assume the founder does make a timely Section 83(b) election. Under these facts, the founder recognizes $500K of ordinary income under Section 83(a), and $500K of LTCG (actually $325K, see below). The 83(b) election “locks-in” the taxable value of the shares to their value at the time of grant. Here, the founder received 50% of a company with a taxable value of $1M (the investor’s contribution), and thus received $500K of taxable value. By making the 83(b) election, the founder “locks-in” this valuation. Accordingly, any appreciation over this value is LTCG, not ordinary income. Thus, the $500K appreciation is taxable as LTCG.

Founder therefore owes approximately $175K of Section 83(a) ordinary income tax ($500K x 35%). It is also important to note that any Section 83(a) ordinary income tax paid is added to founder’s tax basis in the shares. Here, the founder has $0 basis in the shares (he paid nothing for them), leaving him with a $175K tax basis ($0 + $175K). Founder therefore has $325K of LTCG ($500K – $175K), which, taxed at 15%, results in a tax liability of $48.75K. Founder’s total tax liability is thus $223.75K.

Example 1 and 2 are identical but for the simple fact that founder made an 83(b) election in Example 2, and did not in Example 1. And as we can see, this simple step eliminated over $100K of tax liability. In Part II of this series we’ll explore how to reduce this tax burden even further.

By | 2017-08-17T06:20:54+00:00 August 16th, 2017|Taxes|Comments Off on Taxation of Founder Stock & The 83(b) Election