I am frequently asked whether a new tax code Section 83(b) election is necessary when vested stock is subjected to new vesting restrictions. This revesting most often occurs at a financing. The investors request the revesting to ensure that the founders stick around.
Some Quick Background
The default rule, is that the receipt of property in exchange for services causes tax at the time the property (which can be stock) vests. Vesting usually lapses over time or upon the achievement of certain performance milestones. The concept of vesting, in most cases, is that if you leave service before the stock vests, the company can repurchase your stock for the lessor of the original purchase price or fair market value, thus stripping you of any appreciation that occurred during your service. Once your stock vests, you can leave the company and the company either has no repurchase right or has to pay fair market value to repurchase your stock.
A Section 83(b) election is a form you mail to the Internal Revenue Service to tell them you’d like the default rule (tax at vesting) to not apply, and instead want to be taxed at grant, or in a revesting scenario, at the time the vesting is imposed. You have 30 days after grant/revesting to file the election.
Protective Elections
Back to our facts. All Section 83(b) elections are “protective” in the sense that they protect you against tax at vesting. But when I am referring to a protective Section 83(b) election here, what I mean is an election that is technically not necessary. A revesting scenario can be, but is not always, a situation where a Section 83(b) is not necessary.
That said, there’s no downside to filing a Section 83(b) election in a revesting scenario, as long as you file it correctly. It causes no tax, because you get credit for the value of the vested shares as payment for the unvested shares, and it saves the day if it turns out the election was necessary, not protective.
My rule of thumb: File a protective Section 83(b) election at revesting unless you are confident it is not necessary and you don’t know the value of the stock, which you need to know to file the election correctly. If you know the equity value, I would always file a Section 83(b) election within 30 days of revesting.
Necessary or not Necessary?
A Section 83(b) election is necessary[1] at revesting unless the stock has been vested for a sufficient period of time prior to revesting, and the only thing occurring to the shares in question is the revesting. See Internal Revenue Service Revenue Ruling 2007-49 Situation 1.
Sufficient period of time
What is a sufficient period of time? The example in the Revenue Ruling uses 3 years. After that, who knows. I think less than two months is too short, and even two months isn’t sufficient, in my view, if there was a plan at the outset to subject the stock to vesting.
Merely revesting?
A Section 83(b) election is necessary if there are other things happening to the stock besides the revesting. For example:
- If an LLC is converting to a C corp, and the new C corp shares are being subjected to vesting, the election is not “protective” rather is necessary.
- If the C corp is changing its state of organization from California to Delaware at the time of revesting, that is a tax-free “F” reorganization, and thus the election is necessary.
- Are you adding voting rights to the shares? That is likely a tax-free “E” reorganization, and thus the election is necessary.
You get the idea. See Revenue Ruling 2007-49 Situation 2.
Value
You need to know the value of the stock at the time of the revesting to file the Section 83(b) election correctly.
I once represented a company that was being acquired by Amazon. The founder of the company had filed a protective tax code Section 83(b) election which used par as the value (i.e., $0.0001) when that was nowhere close to the actual value of the stock. I was not company counsel when that election was filed, by the way. Amazon treated the election as invalid because par (rather than fair market value) was used, and our pleas that it was merely protective anyway fell on Amazon’s deaf ears. The result was that Amazon treated a portion of the deal consideration as ordinary income and withheld on it, despite the fact that it should have resulted in capital gain.
So, if you are going to file a protective Section 83(b) election, be sure you get it right.
Mike Baker frequently advises with respect to tax code Section 83(b) elections. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] No tax code Section 83(b) election is ever mandatory. When I use the term “necessary,” I mean necessary if you’d like to prevent tax at vesting.