So what is a Section 83(b) election? It’s a letter you send to the Internal Revenue Service letting them know you’d like to be taxed on your equity, such as shares of restricted stock, on the date the equity was granted to you rather than on the date the equity vests. Put simply, it accelerates your ordinary income tax and allows for future value to be taxed as long-term capital gains effectively reducing your tax liability. Please note that Section 83(b) elections are applicable only for stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant.
A Little Background on Taxes
To provide some simple tax background, there are different types of tax rates. The maximum ordinary income tax rate in 2020 is 37%, whereas the maximum long-term capital gains rate in 2020 is 20%. Because the United States uses graduated tax rates (meaning the rates vary based on your income), you may actually be subject to lower rates, but in each case the long-term capital gains rate will be lower than the ordinary income tax rate.
Assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant (if a Section 83(b) election is filed), or at vesting (if no Section 83(b) election is filed), in each case at the applicable ordinary income tax rate. When you later sell your stock, assuming it’s been more than one year from the date of grant (if a Section 83(b) election is filed), or more than one year from the date of vesting (if no Section 83(b) election is filed), the additional gain will be taxed at the applicable long-term capital gains rate. Because the long-term capital gains rate will be lower, the goal here is to get as much of your gain as possible taxed using that rate, rather than the ordinary income tax rate.
Key Takeaway: An 83(b) election enables an individual to pay income tax on restricted shares when they are likely to be at their cheapest value and then pay capital gains taxes on any appreciated value when the shares are ultimately sold.
What is an 83(b) election?
When you make an 83(b) election with respect to restricted stock (RS) or options you receive, you choose to include the value of RS, or the spread of the options (the difference between the strike price—what you pay to exercise the option—and the fair market value at exercise), in your taxable income in the year you make the election, rather than in the future when the RS vests or when you exercise your options after they’ve vested— at which point the value and resulting tax liability may be much higher. To make the election, the stock must be subject to a substantial risk of forfeiture before vesting (e.g., you would lose the stock if you left the company before it vested).
When to consider making an 83(b) election
Consider making an 83(b) election if:
You receive (i) RS with a low market value per share at the time of grant or (ii) options with a strike price that is close or equal to the market value per share
You can afford to pay any costs associated with the election (you will have to pay the strike price for options, and any income tax generated by making the election for both RS and options)
You believe the value of the company’s stock will increase significantly over time
The risk that you will forfeit the stock is small (i.e., you don’t expect to leave the company and, as a result, forfeit the stock)
You believe you will be able to sell your stock later at a higher price
The 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.
The 83(b) election applies to equity that is subject to vesting.
The 83(b) election alerts the Internal Revenue Service (IRS) to tax the elector for the ownership at the time of granting, rather than at the time of stock vesting.
When Is It Beneficial to File 83(b) Election? An 83(b) election allows for the pre-payment of the tax liability on the total fair market value of the restricted stock at the time of granting. It is beneficial only if the restricted stock's value increases in the subsequent years. Also, if the amount of income reported is small at the time of granting, an 83(b) election might be beneficial.
When Is It Detrimental to File 83(b) Election? If an 83(b) election was filed with the IRS and the equity value falls or the company files for bankruptcy, then the taxpayer overpaid in taxes for shares with a lesser or worthless amount. Unfortunately, the IRS does not allow an overpayment claim of taxes under the 83(b) election. Another instance is if the employee leaves the firm before the vesting period is over then the filing of 83(b) election would turn out to be a disadvantage as they would have paid taxes on shares they would never receive. Also, if the amount of reported income is substantial at the time of the stock granting, filing for an 83(b) election will not make much sense.
Who Can File an 83(b)?
An 83(b) election can be made by any individual who receives stock as compensation, subject to a vesting period. If there is no vesting period, the individual would have no other option than to pay income tax on the value of the stock when received.
Saves on income tax: Can save on total taxes due for receipt of restricted stock shares
Defers tax: Avoids paying the bulk of taxes due on shares until they are sold.
Helps with cash flow: Avoids the burden of paying a lot of income tax on assets you cannot sell right away
Requires tax payment be made before even receiving the shares: The 83(b) election requires the tax payment be made in the year when shares are granted rather than received.
Taxes may be paid on assets you never receive or which eventually become worthless: An 83(b) election can potentially result in taxes being paid on shares forfeited if you leave the employer before being vested or shares that eventually become worthless if the company folds.
An 83(b) election can potentially save a considerable amount of tax on the receipt of stock as compensation when there is a vesting period involved. The election effectively enables the recipient to pay income tax on the value of the shares when granted rather than when they are received through the vesting arrangement and would likely be valued quite a bit higher.
The Summit Group's Fractional CFO platform ensures real-time analysis of tax liabilities for founders and employees.
Ready to discuss tax liabilities for your company?
Request a Free personalized Tax Analysis. 801-396-5596