Key Takeaways
- A missed 83(b) election is a company compliance issue, not only the recipient’s personal tax mistake.
- The company’s exposure grows with each vesting date and each increase in valuation.
- The issue can’t be swept under the rug– investors, auditors, and acquirers will ask, and the answer can shape deal terms.
- Build confirmation into the grant process but leave the filing with the recipient.
Overview
Most founders learn about the so-called “Section 83(b) election” early, usually from the lawyer preparing their founder stock paperwork. As discussed here in more detail, the election lets a recipient of unvested equity (corporate stock or LLC interests) to pay tax on the equity’s fair market value when it is issued–which at formation is typically close to nothing–rather than on its value as it vests. The election must be filed within 30 days of issuance, and the IRS does not accept late elections. The IRS now allows the election to be filed online, which has made the mechanics easier but has not changed what happens when the filing never gets made.
Because the election is filed by the individual, founders tend to treat a missed election as that individual’s personal tax problem. It is not. A missed election creates obligations for the company that grow with every vesting date and every increase in the company’s value, and these problems tend to surface when the company can least afford a surprise: a financing, an audit, or an exit.
How a Personal Election Becomes a Company Liability
Without an 83(b) election, the recipient is not taxed when the equity is issued. Instead, each vesting date becomes a taxable event, and the recipient recognizes ordinary compensation income equal to the value of the equity that vest on that date, less whatever was paid for them. Therefore, if the company’s value has risen since the grant, so has the income to be recognized by the equity-holder.
That income is compensation, and compensation carries employer obligations. When the recipient is an employee, the vesting income is characterized as wages and the company must withhold federal income tax, withhold and pay both the employee and employer shares of Social Security and Medicare taxes, and report the income to the IRS. State obligations follow the same income, so companies with employees in Massachusetts or other states have state withholding to address as well. When the recipient is an advisor or other independent contractor, there is no withholding, but the company still has information reporting obligations.
If no one realizes the election was missed, none of this happens. The company does not withhold, does not pay its share of payroll taxes, and does not report the income, and interest and penalties accrue from each vesting date that passes. Some of that exposure may be reduced if the recipient separately reported and paid the income tax, but that does not resolve the company’s payroll tax obligations, and it is not something an investor or buyer will take on faith. If management is made aware of the problem and keeps allowing equity to vest shares without the requisite withholding, the officers responsible for payroll can face personal liability for the unpaid taxes.
Perhaps most glaring: the company’s potential exposure is not fixed at grant. Rather, it grows with each vesting date and with each increase in the company’s valuation.
Everyone on the Cap Table Can Create the Problem
Founders present the classic case of a missed election, but they are not the only culprits. Any recipient of unvested equity can miss the election: an advisor granted restricted stock for joining an advisory board, an early employee receiving a restricted stock award, or a later employee who early-exercises options. Some award types are treated differently, but the issue applies to any grant of equity that is subject to vesting when it is issued.
The problem is rarely that recipients were never told about the election, as recipients typically receive the standard guidance with their grant documents. The more common failure is that neither the recipient nor the company appreciates how serious the consequences of a missed filing can be.
When the Problem Surfaces
A missed election rarely announces itself. It comes to light when someone with tax experience asks about it, and the cost depends on when that happens.
- At formation. Founders have a lot to think about when they form a company, and tax filings are easy to put on the back burner. The issue often surfaces when a lawyer or accountant asks for confirmation that the elections were filed, and the answer is no (or “we don’t know”). This is the least expensive time to find the problem. Shares issued at formation are usually worth little or zero, so early vesting dates may produce modest or no income. Rescinding these grants and issuing new ones, accompanied by properly-filed elections, remedies the issue. But if the issue goes undetected, it will become much harder to fix as the company’s value rises.
- In a financing. In the diligence process for a priced round, or with an attentive SAFE investor, the company may be asked to confirm that 83(b) elections have been filed or to describe its process for making sure they are. Investors do not always ask for copies, but many add a representation about 83(b) elections to the purchase agreement given the tax risk. A company that cannot answer comfortably has a disclosure problem at a moment when it wants a clean closing.
- In an audit or finance review. When a company brings on an outside CPA, a new CFO, or an audit firm, good onboarding includes an evaluation of the company’s potential tax filing obligations. Questions about equity issuances and vesting schedules tend to expose missed elections that no one has thought about since the grants were made.
- In M&A diligence. The most expensive discovery point is at the point of diligence for an acquisition transaction, where a buyer will have leverage while the company is on the cusp of a substantial payday.
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What It Costs at Exit
Buyers want to know they are not acquiring undisclosed tax liabilities and, in deals where we advise on, tax is consistently the area that draws the most diligence scrutiny. That scrutiny reflects experience, with studies of post-closing claims finding that tax matters account for more than a third of claims for breaches of representations and warranties and/or indemnification claims. Transaction diligence typically includes extensive questions and document requests about grants, vesting, and elections, and the answers determine whether the buyer asks for a separate escrow, a special indemnity, or a purchase price adjustment. Those protections often sit outside the general indemnification cap and basket, so the cost of a missed election is effectively borne by every selling stockholder.
To compound the problem, if unvested shares accelerate on a change of control, they vest at the deal price, which can create a significant compensation event at closing with withholding obligations to match.
Prevention Is a Process, Not a Form
The company cannot sign the election for the recipient, and it should not try to take ownership of the filing. Despite the election’s impact on the company, the election is ultimately the recipient’s choice and the recipient’s filing obligation. However, the company can build a grant process that makes the election hard to miss by delivering the election instructions and deadline with every grant of unvested stock, sending reminders while the 30-day window runs, and asking the recipient to confirm by email or through the company’s HR platform that the election was filed.
Gesmer Updegrove LLP does not collect copies of elections, which contain Social Security numbers, and we do not think outside counsel should be the repository of verification document. Rather, that function belongs to the company’s HR and compliance program. If the team does not have experience with equity compensation and payroll reporting, it is worth paying a CPA or payroll provider who does.
If It Has Already Happened
A missed election is often manageable, but the options depend heavily on timing: whether the problem is found in the same tax year as the grant, whether any equity has vested, whether the recipient is an employee or a contractor, how much the equity has appreciated, and whether a financing or sale is underway. Not every case can be resolved without risk. The IRS evaluates corrective steps with the benefit of hindsight, and tax doctrines that look past the form of a transaction to its substance can undercut fixes that look simple on paper. Gesmer Updegrove LLP has experience evaluating these situations and advising companies on how to address and mitigate them, and the earlier that evaluation happens, the more options remain.
Conclusion
Treat every grant of unvested stock as a company compliance event, not just a decision for the recipient. The cost of a missed election is lowest on the day it is discovered and rises from there, so look for it before a financing or an exit forces the question.
Disclaimer
This article is provided for informational purposes only and does not constitute legal, tax, accounting, or business advice. Past results do not guarantee a similar outcome. Every situation is unique, and the issues discussed above may apply differently depending on the facts and circumstances involved. Readers should consult with qualified professional advisors regarding their specific situation before taking any action based on the information contained in this article.
