Silicon Valley Legal Bible（7）Forgot to pay 83(b) Successful startups can't even afford to pay taxes
The Silicon Valley Legal Bible with Forty-Two Chapters, a legal encyclopedia customized for founders. I am Liu Xiaoxiao, a U.S. attorney.
In the last issue, we introduced the Vesting Schedule and mentioned that the Vesting Schedule has a series of knock-on effects, one of which is 83(b). 83(b) is a letter that founders need to send to the IRS, which is usually one page long and must be filed within 30 days after the founders get the Restricted Stock and once it is missed, there is no chance to remedy the situation, waiting for you. It must be submitted within 30 days after the founder receives the Restricted Stock, and there is no chance of remedying the millions of dollars in taxes that await you if you miss the deadline. And because the consequences are so severe, no lawyer wants to help founders file this document. So what exactly is an 83(b)? Why is it so important and so scary?
First, why is there a tax penalty for not filing an 83(b)?
Restricted Stock (Restricted Stock) is a special type of stock that a company will give all of its stock to the founder on the first day he or she joins the company, and then begin to test the founder, usually for four years, and if the test is not passed, the company can still take the stock back. Note that we are not talking about Employee Options here, employee options have a test period first, and only after the test period can you have the opportunity to get the stock, the logic is the other way around.
Restricted Stock: It's like when you were a kid, mom and dad gave you a game console, but told you that you can use it now, but you need to make sure that the next 4 consecutive exams are ranked in the top 10, or else the console will be confiscated. This means that your ability is still relatively strong, and mom and dad believe in you, so they give you the game console first, thinking that you should not abuse it, which is the founder's treatment.
Stock Option: What does this mean? Mom and Dad draw you a pie first, you need the next 4 consecutive exams are ranked in the top 10, in order to buy you a game console. What does that mean? In this case, your level of mom and dad are not too assured, to test first, if you can't pass the test, you won't be able to buy one at all. This is actually the employee option treatment.
So you will find that the logic of Restricted Stock is to give you first, but your performance is not good there is a possibility of being withdrawn, which in the legal point of view, that you are the beginning of the shareholders, but then there is the possibility of loss of shares. But in the perspective of tax law is not so think, the United States tax bureau to Restricted Stock (Restricted Stock) a characterization is subject to a substantial risk of forfeiture, that is to say, because of the risk of loss of equity, in the perspective of the tax on the top of the first day that you actually do not have So pay attention to the legal determination of this place and the So pay attention to this place of legal determination and tax determination is not the same.
Second, the United States tax law basic knowledge popularization
Before we get into the specific 83(b) calculation, let's popularize the basics of the U.S. tax law to make sure everyone understands it.
There are different levels of tax rates in the United States. See these two charts, Ordinary Income Tax Rate (OITR) ranges from 10% to 37%, and those who can start a business are basically those who have a low income and can easily reach the top of the tax bracket, which is 37% in 2023.
The Long-term Capital Gain tax rate, on the other hand, even at its highest, is much lower than the Ordinary Income Tax Rate, with the top tier Long-term Capital Gain tax rate at 20% in 2023.
Based on the previous graph, we can recognize that Long-term Capital Gain rates are lower than Ordinary Income Tax Rates, so if we want to save taxes, we should try to increase Long-term Capital Gain taxes and decrease Ordinary Income Tax Rates.
Note that for simplicity's sake we're only talking about federal taxes, not state taxes yet.
*** Translated with www.DeepL.com/Translator (free version) ***
2023 Tax Brackets and Federal Income Tax Rates
2023 Long-term Capital Gains Tax Rates
Third. How much tax can 83(b) save you?
1.Case Background
On the first day of joining the company, the founder had 1,000,000 shares of Restricted Stock, and the initial price of the stock was $0.0001/share, and the founder took that money to buy the stock, which is a very common set of parameters.
After 4 years, when all the restrictions are gone and the founder's stock is no longer SUBJECT TO A SUBSTANTIAL RISK OF FORFEITURE, the stock becomes $5/share.
Then after 10 years, the company goes public or is acquired by another company, and the stock price is $10/share.
So let's look at the tax difference between filing an 83(b) and not filing an 83(b).
2.Scenario analysis
Scenario 1 : No 83(b) return is filed
In this scenario, on the first day of joining the company, the action of buying the stock is not taxable because the founder is spending money and has not made any money at this time.
After four years, when all of the original restrictions of this time have disappeared and the founder's stock is no longer SUBJECT TO A SIZABLE RISK OF FORFEITURE, the founder actually owns the stock for tax purposes, and needs to pay a tax based on the difference in the price of the stock at this time. Because they hadn't paid 83(b) before, they did have to pay tax at this time, and for tax law purposes, the intervening four years were actually income from labor, why? Because the first day's stock is not counted as the founder's for tax purposes, it is earned through the founder's four years of outstanding performance, so the profits from the intervening four years will be charged at 37% of the Ordinary Income Tax Rate (OIT Rate), and the price of the stock at this time is $5, which is $4.9999 more than the founder's first day's stock price of $0.0001. 4.9999, these are subject to the Ordinary Income Tax Rate of 37%, so the tax is $1.849963 a share. For a total of 1,000,000 shares, the tax would be $1,849,963.
Until the 10th year, when the stock price becomes $10/share, the company goes public, and the founders make $5 per share, all at the Long-term Capital Gain tax rate of 20%, so the average tax is $1 per share, and for a total of 1,000,000 shares, the tax is almost $1,000,000.
Scenario 2: Making an 83(b) Return
In this scenario, on the first day of joining the company, the stock purchase is not taxable because the founder is spending money. And because the founder immediately filed an 83(b), the equivalent of all the restrictions after four years are gone the founder's stock is no longer subject to a substantial risk of forfeiture point in time ahead of the initial price of the first day instead of four years later, the initial price is how much? Isn't it still $0.0001? So the spread is what? 0, so submit 83(b) is not subject to tax.
To four years later, originally at this time all the restrictions are gone, the founder's stock is no longer subject to a substantial risk of forfeiture, the founder in the tax law really owns the stock, need to pay a tax based on the spread of the stock at this time, but because of the previous submission of the 83(b), is not to put this action another 4 years ago? However, since the 83(b) was paid earlier, the action was completed 4 years earlier, so there is still no tax at this time.
Until the 10th year, when the stock price becomes $10/share, the company goes public, and the founders make $9.9999 per share, all according to the Long-term Capital Gain tax rate, then the average tax per share is $1.9998, and for a total of 1,000,000 shares, it is $1,999,800 tax.
3.Situation Analysis
So you will see that in the first scenario, the tax without 83(b) is $2,849,963 and the tax with 83(b) is $1,999,800, which is a difference of 50%, and the difference is almost $1,000,000.
So here, some of you are going to start complaining, that's it? If you pay 83(b), you have to pay almost 2 million dollars in taxes, and you don't save much money, so what are you doing?
However, we should also note that in the case of not paying 83(b), the most terrible point is not the company listed on the $1,999,800, but the fourth year to pay $1,849,963 in taxes Oh, this time the company is still uncertain about the future of the company, perhaps the fifth year of the closure of the company, the stock has not yet been realized, so the fourth year of the payment of nearly two million dollars in taxes is not when the wrongdoer? The company's future is still uncertain. In the case of 83(b), the tax obligation is not triggered until the company goes public in the 10th year, and it is never triggered if the company goes out of business.
So what really scares entrepreneurs is the sight of having to pay $1,849,963 in taxes in the fourth year when nothing happens without paying 83(b).
Again, we're just talking about federal taxes for simplicity's sake, not state taxes yet. Plus the state tax is even more unaffordable.
What kind of person pays 83(b)?
We see here should understand the importance of 83 (b), everyone wants to pay 83 (b), but in fact, not everyone has to pay this, only the founder needs to pay this, some people will say to me, our company is also required to pay 83 (b) of the employee's options.
Yes, there are a few cases where employee options are subject to 83(b), but those are called early exercise cases, which we won't expand on today. Everyone remembers is the founder of the startup company and did early exercise (early exercise) employee options owner on it.
Fifth, 83(b) of the 30-day deadline, expiration date is not waiting
We also need to know that 83(b) is a 30-day deadline (deadline), the deadline (deadline) is a hard dealine (hard deadline), or to be precise absolute dealine (absolute deadline), there is no possibility of any rollover, renewal, but also precisely because of Because of this characteristic, lawyers for startups will not help you pay this 83(b), because the consequences are too serious if you miss it. This 30 days from the beginning of your founder's equity agreement signed immediately began to calculate, so the founders or signed as soon as possible after the submission of 83(b).
Sixth, What happens after the 83(b) is filed?
The answer is that nothing happens. Yes, indeed, nothing happens. While some firms may provide a template in quadruplicate, one for the founder to keep, one for the company to keep, one for the IRS to file, and one for the IRS to return, and also have the founder pay for the return postage in the process of sending the next two copies to the IRS, and include in the letter a request for the IRS to send a copy of the return receipt.
But it turns out that the IRS basically doesn't respond, and only a single-digit number of the nearly 1,000 startups we've worked with have received an IRS response. Then the founders panicked, so important things, once you forget to pay will lose a few million dollars, how even a receipt is not there! Government departments around the world to do things like this, the IRS is also just to receive the letter will not tell you whether he has received.
"So how does the founder prove his innocence?"
You don't have to worry too much about that, because in practice, as long as the founder can prove that he or she has mailed it, it's fine, so as long as he or she keeps a record of it and takes a picture of the envelope when sending it or adds a tracking number to the waybill if he or she doesn't feel comfortable with it, it'll be enough to get a tax break when the company goes public or acquires it.
About 83(b) is very informative and we recommend that you put it in your favorites to watch it over and over again.
The Silicon Valley Legal Bible with Forty-Two Chapters, a legal encyclopedia customized for founders. I'm U.S. Attorney Xiaoxiao Liu, we'll see you next time.
