Re-Vesting Founder Shares at a Series A: 83(b) and QSBS

Is re-vesting founder shares at a Series A taxable?

Usually not, when founders keep the shares they own and simply sign new vesting terms. In Rev. Rul. 2007-49, the IRS held that adding restrictions to stock a person already owns is not a "transfer" under section 83: no income when the restriction is added, none when the shares vest again, and basis stays the same.

The answer changes when the deal exchanges old shares for new restricted shares. Then section 83 applies to the new shares, and an 83(b) election within 30 days is the usual way to keep later growth out of compensation income.

What makes a case not simple:

• The documents cancel and reissue shares, or convert them into a new class, rather than amending the old agreement.
• Some founder shares were still unvested, or no 83(b) was ever filed.
• The exchange may be taxable, which can mean gain on the old shares and a new holding period.
• A founder lives outside the US, or the company was an LLC until recently.

What to gather: the original stock purchase agreements, each founder's first 83(b) and proof of mailing, the new vesting or stock restriction agreement, and the board approval for the round.

What did Rev. Rul. 2007-49 decide about restrictions added to vested shares?

Rev. Rul. 2007-49 decided three cases. Only an exchange for restricted stock brings section 83 back.

The key idea: the "amount paid" for the new restricted shares is the value of the vested shares given up. That is why an 83(b) on an even swap reports no income. Without the election, the ruling shows compensation income at vesting equal to the growth after the swap.

When does re-vesting need a new 83(b) election?

A new 83(b) election is needed only when there is a new transfer of property, which in a re-vesting usually means an exchange of vested shares for restricted ones. The election must be made within 30 days after the transfer and may be filed before it (Treas. Reg. 1.83-2(b)). Revoking it needs IRS consent, which is generally given only for a request filed within the 30 days or for a mistake of fact (Rev. Proc. 2006-31).

Read the documents, not the term sheet's summary. Counsel drafts them, and the mechanism they choose decides which row applies. Form 15620 is the IRS form for the election; how to file it is in founder shares that vest, and how it shows on a return is in reporting the founder stock election.

Should founders file a protective 83(b) anyway?

Some founders file one when the documents leave doubt about whether shares were exchanged, because the 30-day window cannot be reopened. Rev. Rul. 2007-49 does not discuss protective elections, so this is a judgment call, not a rule.

Why some file:

• If the deal is later read as an exchange, a timely election on an even swap shows no income and avoids compensation income at each vesting date.
• The deadline runs from the transfer date, which may be the closing date.

Why care is needed:

• After the 30 days, the election can be revoked only for a mistake of fact, and a mistake about value is not one (Treas. Reg. 1.83-2(f)).
• The value and "amount paid" on the form must be supportable. Entering a value above the shares given up reports income.

What if the shares were still unvested under the first 83(b)?

Shares covered by a valid first 83(b) are treated as owned by the founder for section 83, the same footing as vested shares in Rev. Rul. 2007-49. Adding or extending vesting without an exchange should therefore not be a new transfer. The ruling's facts involve fully vested shares, so this is an extension of its reasoning; confirm it against the documents.

If no 83(b) was filed at formation, the shares are still governed by the original transfer. Income arises when they vest, measured at value on that date (26 U.S.C. 83(a)). New vesting that pushes that date past a priced round can raise the income. The original 30-day window has closed; see founder shares that vest for late elections. If the round swaps these unvested shares for new unvested shares, the new shares generally take the old shares' place under section 83: no gain on the swap, and no new 30-day window from the swap alone (26 U.S.C. 83(g), Treas. Reg. 1.83-1(b)(3)).

Does re-vesting restart the holding period or the QSBS clock?

Not when the same shares are kept. With no transfer under section 83, nothing is newly acquired, so the capital gains holding period and the QSBS holding period run from the original issue. An exchange can change that.

The note: when the new shares are restricted, section 83 sets its own start: just after the transfer with an 83(b), or just after vesting without one (26 U.S.C. 83(f), Treas. Reg. 1.83-4(a)). Rev. Rul. 2007-49 does not say how that rule interacts with tacking in a tax-free exchange, so an exchange route leaves a real question on holding period. QSBS tests and tiers are in QSBS for founders and early employees.

What happens if a founder leaves and the company buys back unvested shares?

The founder sells the unvested shares back at the agreed price, usually cost, and the gain or loss is the price minus basis. When basis equals what the founder paid, a buyback at cost produces little or no gain or loss. If the shares were still unvested and no 83(b) was ever made, the difference between the amount paid and the amount received is ordinary gain or loss (Treas. Reg. 1.83-1(b)(2)).

For shares under an 83(b), a buyback of unvested shares is treated as a forfeiture: the loss is the amount paid minus the amount received, and it is a capital loss if the shares were a capital asset (Treas. Reg. 1.83-2(a)). No deduction is allowed for income reported under the election.

A company buyback can affect other holders' QSBS. A purchase is disregarded when the seller acquired the stock in connection with services as an employee or director and sells it incident to a bona fide termination of those services (Treas. Reg. 1.1202-2(d)); the rule for independent contractors is reserved. Timing and the other exceptions are in QSBS and company buybacks around a round.

What does the company record and keep?

The company keeps the papers that show which route the round took and what each founder filed.

• Board approval and the signed vesting or stock restriction agreements.
• For an exchange: the share exchange or recapitalization documents and support for the value on the exchange date.
• A copy of each founder's 83(b) election; the founder must give the company one (Treas. Reg. 1.83-2(d)).
• The cap table showing original issue dates and the new vesting schedule.

If a founder has compensation income at vesting because no election was made, the company's deduction equals the amount included in the founder's income, and timely information reporting counts as inclusion (Treas. Reg. 1.83-6(a)). With no transfer, or an 83(b) showing no income, there is nothing to deduct.

Example

These examples are illustrative and use US dollars.

Same shares, new four-year vesting

A founder holds 4,000,000 vested shares bought for $400. The Series A adds four-year vesting with a company repurchase right at cost; no shares are exchanged. Under Rev. Rul. 2007-49 there is no income at signing or as shares vest, no new 83(b) is required, basis stays $400, and the QSBS clock keeps running from the original issue date.

Exchange for new restricted shares

The documents instead cancel the founder's shares and issue new restricted shares of equal value, $40,000 in total, in what counsel treats as a tax-free reorganization.

• Year 1: The founder files an 83(b) within 30 days showing value $40,000 minus amount paid $40,000, so $0 of income. Basis carries over at $400.
• Year 4: The shares vest. With the election, no income. Without it, if the shares were then worth $400,000, the founder would have $360,000 of compensation income.

Founder leaves after one year

With the same-shares arrangement, the founder leaves after one year. The company repurchases 3,000,000 unvested shares at cost, $300, and the founder keeps 1,000,000. Basis in the repurchased shares is $300, so there is no gain or loss. If the founder acquired the shares for services as an employee or director and left in a bona fide termination, the buyback is disregarded in testing other holders' QSBS.

Different for you?

• You never filed the first 83(b), or it was late: see founder shares that vest and get startup tax help.
• The round exchanges or recapitalizes founder shares: the 30-day election and holding-period questions need review before closing; see startup tax help.
• You need to report an election on your return: see reporting the founder stock election.
• You want to know whether your shares qualify for QSBS: see QSBS for founders and early employees.
• The company is buying back a co-founder's shares around the round: see QSBS and company buybacks around a round.
• The new vesting comes from converting an LLC to a corporation: see moving a startup into a Delaware corporation.
• You live in Canada: see a Canadian co-founder with vesting US startup shares.