As discussed in our recent QSBS overview, qualified small business stock (“QSBS”) can offer significant tax benefits for founders, advisors, and investors. For high-growth startups, these tax benefits are often well worth the time and brainpower spent planning and structuring for the requirements imposed by Section 1202 of the Internal Revenue Code. However, to fully take advantage of these benefits, understanding and navigating the 5-year holding period requirement under Section 1202 is essential. In this article, we’ll explore one common scenario that illustrates a key consideration with respect to the holding period from the founder’s and advisor’s perspective. I often refer to this scenario as the “83(b) Blunder.”
A startup will typically issue restricted stock to its founders upon formation (and its advisors and early employees shortly thereafter) when the value of those shares is nominal. Those restricted shares are generally subject to a vesting schedule (typically 4 years with a 1-year cliff), and the recipients have the option of filing an 83(b) election under Section 83(b) of the Internal Revenue Code, which offers an important tax advantage for the vesting shares.
A quick sidebar on Section 83(b): Under Section 83, a founder or advisor (or any service provider for that matter, which we’ll collectively refer to as our “Recipient”) who receives property (i.e., stock) in connection with her services to the Company must generally recognize ordinary income equal to the value of that stock when her rights in the stock first become either transferable or no longer subject to a substantial risk of forfeiture. That basically means, as a general rule, our Recipient recognizes income and pays taxes on the value of the stock as it vests. However, Section 83(b) allows the Recipient to make what’s called an “83(b) election” and recognize the income (and pay taxes on the value of the stock) in the year it is granted rather than over time as the stock vests.
Why do we care about this? Because remember the value of the stock on the date of grant is nominal, perhaps as low as par value (or $0.001 per share). We would much rather have our Recipient recognize and pay taxes on a nominal amount of income rather than get stuck with a potentially substantial tax bill in future years when the stock vests and (we hope) is worth quite a bit more.
So what does Section 83(b) have to do with QSBS? Well, it has everything to do with our Recipient’s holding period. When vesting is involved, the 5-year holding period generally begins to run with respect to each share only after it vests (i.e., not on the date of grant). So in our typical vesting scenario (4 years with a 1-year cliff), our Recipient may have as many as 76 different start dates on which the QSBS holding period for her shares begins to run. The holding period for the first 25% of her shares will begin to run on the first anniversary of her grant date. The holding period for the next 1/75th (or 2.083%) of her shares will begin to run one month later (13 months after the date of grant). And during each month thereafter, a new holding period will begin for the shares that vest in that month until all shares have vested. I realize this is not exciting news for our Recipient.
To illustrate the point, if our Company has a liquidity event 5 years after the date of grant, and our Recipient’s shares are included in the sale (whether by choice or required by a drag-along sale), our Recipient will completely miss out on the QSBS gain exclusion and pay taxes on the full amount of her gains from the sale. This unfortunate outcome occurs because the 5-year holding period has not yet elapsed for any of her shares. As far as the IRS is concerned, due to her vesting schedule, she’s merely held 25% of her shares for 4 years, 25% for 3 years, 25% for 2 years, and 25% for 1 year. This is how long she’s held vested shares. To make matters worse, if the value of our Company has grown by, say, 1000x over the past 5 years, the financial impact to our Recipient could be devastating.
Thankfully, the 83(b) election provides a simple yet crucial solution. If our Recipient timely files her 83(b) election (note: this must be done within 30 days of the date of grant, without exception), the holding period for QSBS purposes begins to run on the date of grant, not on the date of vesting. Therefore, in our sale example above, our Recipient would receive the full QSBS benefit with respect to 100% of her shares, thereby allowing her to exclude up to $10 million in gains from her shares in the sale. Put another way, if our Recipient fails to file her 83(b) election or files it even one day late, she could be forced to pay what we affectionately refer to as the “stupid tax” upon the sale of her shares.
So don’t fall for the 83(b) Blunder. Make the timely 83(b) election and enjoy the benefits. We generally advise our startup clients to dedicate personnel to assist their founders, advisors, and early employees in making the 83(b) election. While it is the Recipient’s, and not the Company’s, responsibility to make the election (and we are careful to include language to that effect in the Restricted Stock Agreement), it’s also best practice for the Company to help, which we generally encourage. It’s not exactly a helpful incentive for our key personnel to fall into adverse tax situations.
For this reason, it’s best for founders and entrepreneurs to work closely with sophisticated counsel in the early stages of the startup journey to help navigate these issues.
The Start-up and Venture Capital Practice Group at Riggs Davie PLC counsels founders, entrepreneurs, and investors through early-stage corporate structure decisions and opportunities for leveraging QSBS treatment. For more information about our services, please visit www.riggsdavie.com or contact the author by email at email@example.com.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.