Token Vesting and The 83(b) Election: how to avoid a multi-million dollar mistake as a founder or early employee
One of the costliest mistakes that founders or early employees can make when receiving vesting tokens is forgetting to file an 83(b) election. Failing to do so can not only cause headaches for lawyers, but also lead to an unexpectedly high tax bill.
If you’re a founder or early employee at a company that plans on issuing a token in the future, and you are subject to US taxes, you need to know about the 83(b) election and how it can be a valuable tool for tax optimization by letting you pay taxes on your tokens up front instead of at the time of vesting.
In this blog post, we’ll explore what an 83(b) election is in the context of token vesting, highlight why failing to file one can be so costly, and cover key facts that founders and early employees should know. While this post is primarily focused on the perspective of the founder, the 83(b) is applicable to all individuals receiving vesting tokens (e.g., early employees) as an important step in vesting token management.
This article is provided for informational purposes only and is not intended to be construed as legal, financial, or tax advice. Readers should not rely solely on the information presented herein and should consult with their own legal, financial, or tax professionals regarding their specific situations. The author(s) and publisher make no representations or warranties concerning the accuracy or completeness of the information contained in this article. Reliance on any information provided in this article is solely at your own risk.
What is an 83(b) election?
By default, vesting tokens are recognized as income (and therefore taxed) at the time of vesting, based on their fair market value at that time. The IRS 83(b) election allows for a recipient of vesting tokens to be taxed instead at the time of grant, before any tokens have vested, on the Fair Market Value of all of the vesting tokens at the time of grant.
For founders and employees working at a protocol with a live or planned token, vesting tokens are typically granted as compensation – you have to stay at the company for a number of years to earn all of your tokens. A common token vesting schedule entails monthly vesting over four years, with 25% of the token allocation vesting after a 1-year cliff (wherein if you leave beforehand you earn zero tokens).
Vesting tokens can be granted very early on to founders and early employees. At the time of the grant, the token might be worth very little (close to $0), and the value of the grant could be worth merely hundreds of dollars. By filing an 83(b) election, the founder can pay taxes on the value of the tokens at the time they are granted and then not worry about taxes for those tokens until they decide to sell them.
The multi-million dollar mistake:
If a founder fails to file an 83(b) on their vesting token allocation, then the tokens are by default taxed based on their value at the time of vesting. This can become problematic if the token appreciates significantly in value.
Let’s say the token does really well as the protocol grows. That’s what you hope for as a founder! It takes off, and what was initially virtually worthless becomes a token with a market cap of tens or hundreds of millions of dollars.
Without an 83(b) filed, each vesting milestone may now represent millions of dollars of taxable income that you have to pay taxes on. You could be forced to sell tokens to cover the tax bill, which could be made difficult by slippage or a lack of liquidity. The taxes owed are supposed to be based on the Fair Market Value, which might be lower than the market price, but that can be a lengthy and often difficult argument to have with the IRS.
However, if you had made an 83(b) election, you would have already paid the taxes upfront based on the vesting token grant's initial value, without any need to worry about taxes as they vest and appreciate in price (until the tokens are sold).
Note: The taxable value is net of the cost basis, or the amount paid for the tokens.
83(b) and Token Liquidity
The 83(b) election can also be a valuable tool for founders to avoid liquidity issues at the time of token vesting.
Consider the following scenario:
- A founder was granted vesting tokens and did not file an 83(b).
- The tokens have since increased considerably in valuation and attained a non-trivial Fair Market Value (perhaps through primary or secondary sales).
- Additionally, the tokens are not yet live on any exchange to trade (or have minimal trading volume), or in other words, illiquid.
Once those now-valuable tokens vest, the founder will not only owe higher taxes based on the increased token valuation, but will also be unable to sell the tokens to cover the tax bill, having to cover it out of pocket.
To avoid ending up in this situation, lawyers will usually either ensure that an 83(b) is filed, or utilize a different legal structure such as Restricted Token Units that can allow for deferred vesting until a liquidity event (the details of which are outside the scope of this blog post).
How do I file an 83(b)?
An 83B must be filed or postmarked within 30 days from when the token grant is finalized (typically marked by the recipient remitting payment for the grant to the company) - leaving a fairly short window for a decision that can have long-term ramifications.
One of the biggest headaches for startup lawyers is when a founder forgets to file their 83(b). It can be very costly and complicated to fix, though not impossible.
For record purposes, the recommended way to file an 83(b) is via certified mail with two copies and a stamped self-addressed envelope, requesting a return receipt, sent to the IRS service center where you would otherwise file your tax return. That way there is a record of the IRS signing for it, and if the copy and envelope are enclosed they will also return a stamped version of the second copy.
In 2023, the IRS also extended its temporary policy on e-signatures to allow for e-signatures on 83(b) election. This makes it easier for tools and service providers to facilitate the filing of an 83(b) election on behalf of a founder.
Is an 83(b) election always a good idea?
When you file an 83B election, you are opting to pay taxes on the value of all of your vesting tokens at the time of grant. This largely assumes three conditions:
- You can afford the up-front tax bill
- You think the value of the tokens will go up and are making a bet on saving money on taxes overall.
- You are comfortable paying taxes on all vesting tokens, knowing that if you leave early, you may not earn all of them.
So if one or more of the above things are not true, an 83(b) election might not be right for you.
- If the token price is too high by the time of grant, the tax bill could be unaffordable or not worth paying upfront.
- If the token value goes down after the grant, then you may have ended up paying more in taxes upfront than you would have otherwise.
- If you leave the company before all the tokens are vested, you may have spent money to pay taxes on tokens you will never receive.
In most cases for founders and early employees, though, the token is basically worthless at the time of grant and an 83(b) election is a no-brainer: the value can't go much lower, but could go a lot higher, and the amount you’ll have to pay for them is very low.
As the token price goes up over time, companies may move away from structures that support the 83(b) election and towards structures like the RTU and Token Option (see below).
Is filing an 83(b) always an option?
An 83(b) election can only be filed on vesting property, defined by the property being non-transferable or subject to a substantial risk of forfeiture (see 83(b) text at the end of this post). One compatible structure is the Restricted Token Award, which awards vesting tokens subject to a repurchase right by the company upon termination of service.
There are several token compensation structures that are not eligible for an 83(b) election, including Restricted Token Units and Token Options.[1] These structures are often employed once tokens become too expensive to grant using restricted token awards, or if standard time-based vesting could result in facing the liquidity issues described earlier.
There is also a novel alternative structure pioneered by some law firms called the future token interest which some law firms consider compatible with an 83B filing, though this is not widely implemented and beyond the scope of this article.
Closing Thoughts
Deciding whether or not to make an 83(b) election can be a complex decision, but can prove very beneficial for founders and employees receiving vesting token grants at an early company stage - and potentially enable millions of dollars in future tax savings.
If you're trying to determine whether or not an 83(b) election is the right choice for your circumstances, do your research and consult with a tax advisor or lawyer. If you’re looking for an introduction, or want to discuss anything else related to token vesting, token lifecycle management, or crypto vesting tracking- our team is always more than happy to chat.
Appendix: U.S. Code Section 83(b) original text
The legal text of section 83(b) is actually quite short, and included here in full as reference.
(b) Election to include in gross income in year of transfer
- In general Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income for the taxable year in which such property is transferred, the excess of—
(A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over
(B) the amount (if any) paid for such property.
If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture.
(2) Election
An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary.
[1] Options can have an early-exercise mechanism. In that case, they could be exercised early, leaving the recipient with vesting tokens that could then be subject to an 83(b) election.
