Section 83 of the Internal Revenue Code applies to various forms of deferred compensation, including equity compensation such as stock grants that are subject to vesting (often referred to as restricted stock). In the startup arena, this most often applies to stock issued to founders and other persons, subject to a repurchase right in favor of the issuer at the issue price, that lapses over a period of time so long as the recipient is still employed at the scheduled vesting date. That lapsing is what we refer to as "vesting." Under Section 83(a), there is normally no taxable event when the recipient receives the stock subject to the repurchase right. Instead, the recipient incurs tax when the right to the stock is no longer subject to "substantial risk of forfeiture" or the interest in the stock is transferable. When the stock becomes vested, the recipient is taxed on the difference between what she paid for the stock and the fair market value of the stock at the time of vesting. Here is a typical example: 1,000,000 shares of stock are issued to a founder at $.01/share (or $10,000), with the stock vesting 1/4 after 1 year, with the remainder vesting 1/36th per month over the following 3 years. On issuance, there is no tax effect. After 1 year, if the stock is worth $20/share, the founder will be taxed on the difference between the $.01 she paid for each share and the $20 fair market value at that time, multiplied by the 250,000 shares that vested on that date. So, the founder would pay tax at her ordinary income tax rate on $19.99*250,000 shares = $4,997,500. The increase in value is a great thing for the founder. However, this results in what we refer to as "phantom income" or taxable income on amounts not actually received, as the founder isn't actually receiving $4,997,500, but still has to pay tax on that amount.
To avoid this harsh result, we normally encourage restricted stock recipients to file an 83(b) Election. Such an election effectively converts the recipient from an employee receiving compensation in the form of stock to an investor who purchased the stock, for tax purposes. The 83(b) Election is an election by the recipient taxpayer to pay tax in the issue tax year on the difference between the fair market value of the stock on the date of issuance and the price paid for the stock, even though the recipient may not get to keep the stock due to the vesting provisions. In our example above, the founder paid $10,000 for the stock and the stock was worth $10,000, so the difference between the two amounts would be $0. So, there is no downside to such an election in this case. However, if the founder received the stock for $0, she would have paid tax on $10,000 in income in the year of the grant, even though she may not get to keep it if she leaves the company before the stock is fully vested.
Note that an 83(b) Election must be filed within 30 days of the stock issuance and again with the taxpayer's tax return for the year of the stock issuance. Many people miss this deadline, which prevents them from being able to make the election, which can have dire tax consequences.