Understanding 83(b) elections

If you're a startup employee or founder who has been issued equity compensation by a company, you've likely heard the term 83(b) elections. Although the saying goes - there's nothing certain in life except for death and taxes, this Internal Revenue Code (IRC) provision gives you the chance to minimise any tax owed to the Internal Revenue Service (IRS) at a later date.

By 'locking in' the full fair market value of the restricted stock at the time of grant and paying the compensation income tax earlier (yes, that sounds counter-intuitive, but trust me, it can pay off in a BIG way), you can effectively reduce your taxable income at the time of sale using the lower tax rates from capital gains. That's a lot of jargon, but bare with me!

In this guide, we will cover everything you need to know about the 83(b) election; what it is, how it works, when you have to make it and whether you should make the election (or not).

83(b) election, explained

What is 83(b) election

Dubbed an '83(b) election' from the section of the Tax Code, section 83(b) is a US-specific tax provision that lets restricted securities that have been exercised (including stock options) pay taxes on the total fair market value of their stock at the time of issuance (while the value of the stock is significantly lower), as opposed to when the stock is fully vested (and the value of the stock could be a lot higher!). This is called an 'early exercise' (note: not all companies, and in turn, their equity incentive plans, have the option to do so - so make sure to check!), Assuming the valuation of the company increases over time, a section 83(b) election can result in a substantial tax break.

How does a section 83(b) election work

..and what are the tax implications of making one?

Simple! Let's say you receive restricted stock grant (or options) from your employer as part of your compensation package. If your equity grant allows you to exercise early (at the time you're issued the grant), you have the option to make an 83(b) election, before they're fully vested. The election has to be made within 30 days of receiving the offer - otherwise you won't get the tax benefits!

So, what are the benefits?

Stock options (ISOs and NSOs)

Generally with stock options you may need to pay ordinary income tax (for NSOs), or, in certain cases, Alternative Minimum Tax (for ISOs), on the spread between the Fair Market Value and the strike price, at the time of exercise. If you exercise early (and make an election), you are effectively accelerating the recognition of income and, in turn, the taxing point, which means you will avoid paying any potential increase of the spread as the options continue to vest. This concept also applies to RSAs.

Restricted stock awards (RSAs)

RSAs are a common form of equity compensation amongst early-stage startups - often used for early employees, and even founders. The value of these awards is usually very low, often just a fraction of a cent per share. If you decide to file an 83(b) election when you receive an RSA, you will recognize this minimal value as ordinary income upfront. By doing so, you'll have limited tax liability at that time. When you eventually sell these shares, you'll be subject to CGT on the difference between the FMV at the time of sale and the low value at which you initially received the RSAs.

In contrast, if you don't file the election, the spread between the FMV at vesting and the low purchase price will be treated as ordinary income for tax purposes.

RSA example

To give this information some colour, let's look at an example of an RSA.

Scenario: Alex and Sam work at an early-stage company. They receive RSAs valued at $10,000 at the time of grant, the stock price increases from $10 to $100 per share at vesting.

Alex: Makes a section 83(b) Election

• By filing a section 83(b) election, Alex recognizes the $10,000 value as ordinary income at the time of grant.
• Let's assume Alex's ordinary income tax rate is 25%.
• Alex pays $2,500 in taxes ($10,000 x 25%) at the time of grant.
• When Alex sells the shares at the FMV of $100 per share, they only incur capital gain on the appreciation from the grant date to the sale date.
• The appreciation is $90,000 ($100 FMV - $10 initial value per share) for the entire RSA.
• Let's assume Alex's CGT rate is 15%.
• Alex pays $13,500 in CGT ($90,000 appreciation x 15%) upon sale.

Sam: Does Not Make a section 83(b) Election

• Without making an 83(b) election, Sam does not recognize the income at the time of grant.
• When Sam sells the vested shares at the FMV of $100 per share, they are subject to ordinary income tax rates on the entire appreciation of $90,000 from the grant date.
• Let's assume Sam's ordinary employment income tax rate is 35%.
• Sam pays $31,500 in employment taxes ($90,000 appreciation x 35%) upon sale.

In this example, Alex paid $2,500 in taxes at the time of grant and an additional $13,500 in capital gains tax upon the sale of the RSA. Sam, on the other hand, paid no taxes at the time of grant but incurred a higher tax liability of $31,500 in ordinary income tax upon the sale.

Making the election can be a smart move if you believe the company valuation will increase significantly in the future, as it allows you to lock in a lower tax rate and potentially save money in the long run. But buyers beware - if you make the election and then forfeit your RSAs before they vest, or the company fails, you won't be able to recoup the amount paid upfront. It's a risk that individuals should consider, especially in cases where the value of the RSAs is uncertain or if there's a possibility of leaving the company before vesting occurs.

As always, it's valuable to consult with a tax professional before making the election, as it can have complex tax implications.

Pros and Cons section 83(b) elections

As with any tax strategy, there may be advantages and risks that need to be factored into your decision.

Pros

• Locking in a lower tax rate. By making an election, you are essentially locking in the tax rate at the time of grant. If your equity grant appreciates significantly in value over time, you could end up paying a much higher tax rate if you wait until the time of vesting to be taxed.
• Accelerating capital gains. If you hold your equity grant for more than one year, you will be eligible for long-term capital gains tax treatment when you sell your shares. By making a an election, you are accelerating the start of your holding period, which means that you may be able to take advantage of long-term capital gains treatment sooner.
• Avoid AMT. If you receive a large equity grant, you may be subject to the AMT, which can be a significant tax burden. By making an election, you may be able to avoid the AMT altogether.

Cons

• Risky. If the restricted stock never vests, or the valuation of the company doesn't increase, you will have been taxed and essentially forfeited the cash. Due to liquidity restraints in private markets, you may not even be able to sell your stock.
• Requires cash upfront. Making the election requires you to pay taxes on the value of the stock at the time of grant, which can be a significant amount of cash upfront.
• No tax deduction for losses. If the stock loses value, you cannot take a tax deduction or income tax return for the loss on your tax return.

When to consider making an 83(b) election

Making an 83(b) election is not always the best option, and it is important to consider your individual circumstances before making a decision. Always speak to your tax advisor and make sure it makes sense! Here are some factors to consider:

1. The likelihood of stock appreciation

If you believe that the value of the stock will increase significantly over time, submitting the 83b election may be a good idea. This is because you will pay taxes on the value of the stock when it was granted, which could be much lower than the value of the stock when it vests.

2. Your personal tax situation

If you are in a lower income tax bracket now, it may be beneficial. If, say, your grant is scheduled to vest in 4 years, your income tax rate can potentially increase at any point during that period. In this scenario, paying income taxes on the value of the stock at the time of grant means a lower tax rate than at the time it vests.

3. Your cash flow situation

Making an 83(b) election requires you to pay taxes on the value of the stock when it is granted, which could be a significant amount of money. If you do not have the cash available to pay the taxes, it may not be feasible and pose a substantial risk.

How to make an 83(b) election

1. Consult with a tax professional
2. Fill out the 83(b) election form
3. Submit the election form to the IRS within 30 days of receiving
4. Keep a copy of the form and any supporting documents for yourself and your company

Section 83(b) election form

The form will need to include the following information:

1. Your name, address, and social security number
2. A description of the property (issuing company name, number and type of shares and any restrictions on shares) for which the election is being made
3. The date the property was granted or purchased
4. The fair market value of the property at the time of transfer
5. The amount you paid for the property (if any)
6. Amount to be included in your gross income
7. A statement that you are making an 83(b) election

Section 83(b) can be a valuable tool for early employees or a startup founder who wants to save on taxes. By making this election, you can pay taxes on the fair market value of restricted stock grant that are subject to vesting, at the time of issuance. As always, it's important to assess your individual circumstances and consult with a tax professional before making the decision and submitting the completed election form.

Quick-fire Q&A

FAQs about the 83(b) election

What happens if I do not make an 83(b) election?

If you do not make an 83(b) election, you will owe taxes on the fair market value of the stock when it vests.

Do I have to make an 83(b) election for all of my stock grants?

You can choose to make an 83(b) election for some of your stock grants and not others.

What happens if I miss the 30-day deadline to make an 83(b) election?

If you miss the 30-day deadline, you cannot make an 83(b) election and will be pay tax on the value of the stock as it vests.

Can I make an 83(b) election for stock options that have already vested?

No, you can only make an 83(b) election within 30 days of receiving the stock.

What happens if I leave the company before the stock vests?

If you leave the company before the stock vests, you may lose the right to the stock or be subject to a forfeiture. You may also have to pay back any taxes you saved by making an 83(b) election.