Several years ago, after diagnosing what seemed like my one-thousandth patient with a preventable pregnancy complication and the realization that very few women were receiving recommended preconception testing which was leading to many of these complications, I decided to start a direct-to-consumer preconception testing service.
The direct-to-consumer idea had already been done with tests for fertility, sexually transmitted infections, and genetics, so preconception testing seemed like the natural next step. Unfortunately for me (and my business partner), I was trained in medicine and not business.
After a lot of research and some good fortune, PreConception Inc. was born (no pun intended). As most startups do, we incorporated as a Delaware C-Corp operating as a foreign entity in California. As one might expect, this process is accompanied by many legal documents, including a very important, yet often overlooked, IRS form called an 83(b) election. Luckily we used a service called Clerky that assisted us with the incorporation process and filing our 83(b) elections.
Company Incentives Through Common Stock
With a projected 20% annual growth rate for telemedicine, it’s likely that many of the physicians reading this will be approached to join a digital health startup at some point in the future, often with the incentive of compensation through company stock. For a physician joining the next Facebook, this can be an enticing offer, however, understanding the importance of an 83(b) election at the time that company stock is issued is critical to minimize your future tax burden.
The first thing to know about startup stock is that it will usually fall into one of two main classes — common stock and preferred stock.
Preferred stock is provided to investors.
Common stock is typically issued to founders, advisors, employees, etc. Common stock subjected to a vesting schedule is referred to as restricted stock.
Restricted Stock Vesting Schedule
The most common vesting schedule for startups is a 4-year vesting schedule with a 1-year cliff. This means that 1/4 of your shares will vest at the one-year anniversary of stock issuance, with 1/48th of the total original shares vesting every month thereafter until your shares are fully vested at 4 years. This vesting schedule protects the company should you leave before one year and rewards you for your time during an early stage of the startup when growth is often rapid.
Tax Problems with Vesting Schedules
This brings us to the importance of an 83(b) election. When shares are subject to a vesting schedule, the IRS considers each vesting period to be a taxable event. For individuals with a 4-year vesting schedule as described above, this means that after the first year, a taxable event occurs every month.
For the purpose of taxation, the IRS considers the difference between the fair market value of the shares at the time that vesting occurs and the price you purchased the shares for (which for early startups can be as low as $0.0001/share) to be taxable income, even though you're not typically receiving any actual money from the vesting of your stocks.
This can cause two problems for individuals with restricted stock:
- It can be extremely difficult to pay a large tax bill when your shares are from a fast-growing company with a high valuation that is not yet providing significant income to you (as is the case for many startups) and
- You (or your accountant) will need to perform this calculation every single month for 3 years.
The Critical 83(b) Election Solution
In an attempt to simplify this process, the IRS allows recipients of restricted stock to make an 83(b) election for “alternative tax treatment”. This makes the purchase of the stock (at the $0.0001 price, in this example) to be the only taxable event, allowing you to avoid paying tax on the increased value of your stocks over your vesting period.
The really critical component of this process, however, is that you only have 30 days from the date of stock issuance to manually sign the 83(b) election form, mail it to the appropriate IRS office (this varies by state), and provide a copy to your company. If you miss this deadline, there is no easy way to correct it and you're likely stuck with the standard vesting tax structure as described above.
Because this process is time-sensitive and has long-reaching implications, Clerky recommends the following:
- Mail your 83(b) election to the IRS using USPS certified mail with a request for a return receipt
- Keep the certified mail receipt and the return receipt in your records
- Include a copy of your 83(b) election form, a self-addressed, stamped envelope, and a letter requesting acknowledgment of receipt. The IRS will usually stamp your copy of the 83(b) election and mail it back to you.
Like most of us, startup founders are typically not experts on tax law and therefore may not have a great understanding of this process themselves. If you’re receiving company stock as compensation, my suggestion is to not rely on the company’s founders or HR person to educate you on these nuances. Rather, ask questions and do your due diligence before accepting any form of company stock.
Have you received company stock as part of your compensation? How did you learn about the 83(b) election? Comment below!