While this 6th installment of the Ten Legal Mistakes Made by Start Ups examines the "83(b) Election," the underlying theme is the need to engage an accountant who understands your tax profile and a lawyer who understands the accountant.
Myth #6: "I don't need to be concerned with tax issues because this is just a start up."
I constantly hear founders state that they can wait on tax advice, and for that matter legal advice, until they can "afford it." To that, my response is that as a founder you cannot afford to wait. One significant example relates to the common mistake founders make in failing to make the 83(b) election as it relates to restricted stock.
If the start up engaged an experienced business lawyer, the founders would have received advice regarding the importance of granting restricted stock (i.e., stock that is subject to forfeiture) that vests upon certain dates or milestones. Under Section 83 of the Internal Revenue Code, a founder can make an election resulting in the acceleration of the taxable event to the date of the grant rather than the date the stock actually vests. This is commonly referred to as the 83(b) Election.
What is the advantage of the 83(b) Election? It allows the founder to pay ordinary income tax on the fair market value of the stock as of the grant date rather than the vesting date. The assumption being that stock in a start up company will have substantially less value than at the later vesting date when presumably the value of the company has increased, and with it the fair market value of the shares. The 83(b) Election means the founder will likely pay very little tax on the granted restricted stock. If, after the stock vests, the company and thus the shares have appreciated, the founder will pay capital gains tax on any eventual sale of the shares.
What if I fail to make the 83(b) Election? The failure of the founder to make a timely 83(b) Election means that when the stock vests, the founder will have to pay tax as of the vesting date. While the founder may be pleased that the company is doing well and its valuation has dramatically increased from the start-up days, the founder will be very unhappy to learn of a tax liability based on the value of the shares at the time of vesting at tax rates applicable for ordinary income.
When must the 83(b) Election be made? The election must be made within 30 days of the grant of the shares by filing notice with the IRS
Lesson: An 83(b) Election is just one significant pitfall that start ups/founders should be aware of -- demonstrating why mistake number six made by start ups is not just the failure to make the 83(b) Election, but the broader mistake of failing to engage a good accountant and a business lawyer to address important tax matters facing all start-ups.