Founders have one huge advantage if their venture succeeds. While mere mortals (me included) have to work for salary and wages and have to watch a spate of employment taxes be removed from every paycheck along with federal income taxes up to 39% (plus up to 12% in state income taxes in places like California), a founder banks his or her efforts in a capital asset called stock and, when that stock eventually sells, the same sort of labors that others exert to earn a living suddenly yield rewards that are free of most of the employment taxes and that are taxed at favorable capital gains rates.
The payday arrives and not only are the amounts bigger than what most can get through their labors but the founder gets to keep a far higher percentage after all taxes. This is truly a founders’ privilege. Take advantage of it if you can.
This manner of magic (or legerdemain, if you take a negative view) exists only because of the way in which founder sweat equity is taxed.
Founders work in a company just as other employees do but get a large part of their compensation in stock. Let us take Founder A, who gets a below-market salary and who also vests a portion of his total stock grant every month. There is nothing in theory that would prevent the tax authorities from saying that Founder should be taxed each month as ordinary income on the value of the stock as it vests. In other words, if Founder A’s stock is worth $1/sh and 25,000 shares vest in a given month, the IRS could in theory say that Founder A just got $25,000 in taxable income and require him to pay both income and payroll taxes on that sum. In that way, stock compensation would be taxed just the same as salaried compensation.
It may surprise you to learn that this bizarre-sounding theory is in fact existing law already on the books and founders would be subject to it *except* for the saving grace of the 83(b) election.
The 83(b) election is (not surprisingly) found in Internal Revenue Code § 83(b). What most people don’t know or really care is that right next to it on the books lies IRC § 83(a). And 83(a) is a law that precisely says you get taxed on stock compensation just as you would on salary.
83(a) says that, when you perform services and get paid with property, the value of that property is taxed to you as service income. You work for stock. You get paid with $25,000 worth of stock. You realized $25,000 in taxable income and you pay both income and employment taxes on that income. Just as you would if it were cash compensation paid to you as salary. Only worse. Because the stock you get is only a piece of paper that you typically can’t sell for a long time, if ever.
And if its value goes down to zero because the company fails, you still will have paid full taxes on that stock when you got it. If it loses its value, you can deduct the loss as a capital loss, which can be offset against other capital gains you may have but that can be offset against ordinary income at the rate of only $3,000 per year (with the balance carried forward).
So, in our Founder A case, let us say Founder A pays $8,000 worth of income tax for getting the $25,000 worth of stock, plus another $2,000 in employment taxes. The net effect of this is that he gets paid with a piece of paper for his labor and has to pay $10,000 in taxes to the government for the privilege. If he happens to win big with that stock eventually, then any gain in excess of the $25,000 initial value is taxed at capital gains rates.
That is a clear tax benefit. But what if the stock instead later becomes worthless? At that point, he can start deducting the capital loss at the rate of $3,000 per year against ordinary income (or more if he has capital gains). The net result in that case is that Founder A had to *pay* $10,000 for whatever labor it took to earn that stock, for which he otherwise got zero (insofar as the compensation is concerned), and he only later may get gradual recoupment of his loss. This is a sucker deal royale and, if that is how founders had to work, well, there would be very few who would be willing to be founders.
But don’t founders pay for their stock up front when it has trivial value, thereby avoiding the problems of paying large taxes for receiving that stock?
Yes, they do but what they get is restricted stock and not an unrestricted grant and this raises special issues concerning the 83(a) tax risk.
What is restricted stock? It is a grant of stock made to a founder (or other recipient) who pays for it up front and who owns it up front but who can forfeit it if his or her service relationship is terminated, triggering a right or option held by the company to buy it back at what the person paid for it. Again, Founder A gets 2M shares at a cost of $0.0001/sh and pays for those shares up front either with a small check for $200 or with an IP assignment said to be valued at $200.
The company retains a right or option to buy back those shares at the same $0.0001/sh price if Founder A leaves the company or otherwise has his or her service relationship terminated. That company option lapses progressively over time, let us say at the rate of 1/48
th per month (which, in this case would mean that 41,667 shares would vest during each month of Founder A’s service). This means Founder A only truly owns the shares as each part vests. So, if this stock at some point is worth $1/sh, and Founder A’s service is terminated, then each unvested monthly piece of 41,667 shares would be worth $41,667 but could be repurchased by the company for $4.67 and Founder A would effectively forfeit its entire value.
So how does this tie in with the 83(a) tax risk? Well, 83(a) taxes you on the value of property received in exchange for services performed. But when is it received? Well, not until the risk of forfeiture goes away and it is truly yours to own. So, in our example, Founder A did not receive $200 worth of stock on the date of grant. In fact, assuming that all the stock was subject to vesting, Founder A received nothing on the date of grant as far as 83(a) is concerned.
Instead, Founder A receives (and is taxed on) each stock increment as it vests and as the risk of forfeiture goes away. But, and here is the kicker, Founder A is taxed on each such increment based on its value as of the date of vesting. So, for a 41,667-share piece that vests, say, two years in when the stock is worth $1/sh, Founder A is deemed to have gotten $41,667 worth of taxable income when that piece vests. And so on with each vesting event: you determine what the stock is worth at the time and you tax it accordingly.
So, under existing tax laws as embodied in 83(a), founders are taxed just as other employees as they get paid in stock and they do indeed get the super sucker-deal of the century in paying income and employment taxes just to get a piece of paper that may or may not have value over time and that they can do nothing but hold in the interim.
This, then, is what the 83(b) election deals with and (for our purposes) it is the *only* thing that it deals with: under 83(b), you can specifically reject the horrific tax treatment you would otherwise get under 83(a) and instead elect to be taxed on the entire value of your grant as received on the date of grant. So, in our example, Founder A gets $200 worth of stock and pays $200 for it, realizing zero income as the difference. With an 83(b) election, this founder tells the IRS that he or she will pay tax on that zero income item as opposed to having to pay tax on each increment of stock as it vests at the then prevailing market value. This is the bargain of the century for founders. Don’t neglect to do it.
An 83(b) election must be made within 30 days of the date of grant and has certain other formalities as well (e.g., must have spousal consents). It may seem like a trivial item in the checklist of things to do at the time you form a company and issue stock, but it is a vital fulcrum to the whole startup world. Without it, the taxation of founders’ stock would be a disaster. With it, everything falls into place. You get your stock up front. You buy it at a cheap price. You pay no tax whatever on it until the day you sell it. You then pay at favorable capital gains rates. And you escape employment taxes to boot.
As a founder, you take huge risks. Make sure to take the steps needed to ensure that you capture the value that makes taking those risks worthwhile.