Founder vesting and the 83(b) election: the 30-day deadline explained

Two founders split a company 50-50 on day one. Eight months later one of them leaves. Without vesting, the person who walked away still owns half of everything the remaining founder builds over the next decade. That scenario is why nearly every institutional investor expects founder shares to vest, and why founders who skip it usually end up adding it later under worse terms.

Vesting on founder stock works differently from employee stock options, and it comes with a tax decision, the 83(b) election, that has one of the least forgiving deadlines in startup life.

How founder vesting actually works

Founders usually buy their shares outright at formation for a nominal price. The shares are theirs from day one, with voting rights. What vesting adds is a repurchase right: if a founder leaves before a set schedule completes, the company can buy back the unvested portion, typically at the original low price.

This is often called reverse vesting, because the founder starts owning everything and gradually earns the right to keep it. A common pattern is a four-year schedule with a one-year cliff, meaning nothing vests for the first year and then a portion vests at once, with the rest vesting monthly after that. The schedule is a convention, not a rule, and founders sometimes negotiate credit for time already worked.

Acceleration terms decide what happens on a sale. Single-trigger acceleration vests some or all unvested shares when the company is acquired. Double-trigger acceleration requires two events, typically an acquisition followed by the founder being terminated without cause or resigning for a defined good reason. Acquirers tend to prefer double trigger, because they want the team to stay.

Where the tax problem comes from

Under Section 83 of the tax code, property received in connection with services that is subject to a substantial risk of forfeiture is generally not taxed when it is received. It is taxed as it vests, as ordinary income, on the difference between what the shares are worth at that time and what was paid for them.

For a founder, that can be brutal. If the company raises money and the share value rises, each monthly vesting date creates taxable income based on the new value, even though the founder has sold nothing and has no cash from the shares to pay the bill.

What the 83(b) election changes

An 83(b) election tells the IRS to treat the shares as if they were fully vested at the moment they were received. Any income is measured on that day. If the founder paid fair market value for the shares, which is common at formation when the shares are worth very little, the income to report is zero.

Two further effects follow. Later increases in value are not taxed as each tranche vests, and the holding period for capital gains purposes generally starts when the shares were received rather than as they vest. That holding period can matter for long-term capital gains treatment and for other provisions keyed to how long stock has been held.

The election is not free of risk. If the founder pays tax up front based on a meaningful value and then leaves and forfeits the unvested shares, the tax paid on the forfeited portion generally cannot be recovered. That is one reason the election is most attractive when the value at grant is low.

The 30-day window

The election must be filed with the IRS within 30 days after the shares are transferred. The window is set by statute. It is not extended for weekends you did not notice, lawyers who forgot to remind you or a company that was busy fundraising. A late election is generally treated as no election at all.

The IRS has published guidance with sample election language and examples of how the tax works out, and it now offers a form that can be used to make the election. Founders should also give a copy to the company, and keep proof of timely mailing or filing. Acquirers and later investors routinely ask to see it in diligence.

What to do this week

If you are forming a company, put founder vesting in the stock purchase agreements from the start. Investors will ask for it anyway, and setting it up yourselves lets the founders choose terms rather than accept them.

If you receive restricted stock subject to vesting, put the 30-day deadline on a calendar the day the shares are issued, and confirm who is preparing and sending the election. Send it in a way that produces dated proof.

If you think you missed the window, talk to a tax adviser immediately rather than assuming nothing can be done. Options are narrow, but some situations can be restructured going forward. And if you are re-vesting shares as part of a financing, ask counsel whether a new election is needed for that transaction too.

This is general information, not tax advice. Rates and thresholds change; confirm current figures with the agencies linked below or with your accountant.

Sources

IRS — Form 15620, Section 83(b) Election (PDF)

IRS — Internal Revenue Bulletin 2012-28 (Rev. Proc. 2012-29, sample 83(b) election)