The 83(b) election, named after the provision in the Internal Revenue Code that permits this strategy, allows an employee or founder of a business a special option to prepay the tax on the total restricted stock’s fair market value at the time the equity is granted instead of the time when the equity is vested; thus paying taxes on a total equity on a lower valuation (assuming the value of the stock increases over time)
The Pros and Cons of the 83(b) Election
When a founder or an employee receives equity compensation, that stake is subject to ordinary income tax. However, the equity granted often does not vest until sometime later, based on a preset vesting schedule. E.g., 25% vests annually starting on the 1st work year anniversary.
Under normal situation, the income tax obligation is not triggered until the equity vests. By the time the equity vests, it is often worth much more than it would have been worth when the equity was issued. The result is that the founder or employee will end up paying a significantly higher tax on the vesting date compared to the date that they first received the stake. The 83(b) election allows founders and employees to choose to incur the tax burden right away, instead of waiting.
If you expect your restricted stocks to increase in value between the grant date and the vesting date, then you may wish to accelerate the recognition of tax on your equity. Any appreciation from that point on is treated as capital gains at the date of sale, which is taxed favorably if the equity is held for at least one year. This acceleration can occur if you timely make an 83(b) election with the IRS.
However, if the 83(b) election is not made, and the stock price increases, then you will end up paying ordinary tax on a higher valuation on each vesting date period. If the value of the shares have significantly increased in that first year and over the next vesting period, then the difference in tax can be substantial.
When does it not make sense to make the 83(b) election?
The 83(b) elections is an irrevocable election; the IRS does not allow for an overpayment claim if you make the 83(b) election and the equity value decreases or the company becomes bankrupt.
Although the election makes sense if you believe in the fundamentals of the company, and believe the value of the company to continue increasing. There are situations where the election does not work to your advantage, including the following:
- If you expect the value of the stock to go down, then it would make sense to wait until your equity vests then recognize ordinary income. If you already made the election and the value went down, you would have paid more taxes than necessary.
- If you expect to leave the job before vesting, or to meet applicable milestones.
Additional considerations:
- The 83(b) election must be filed within 30 days of receipt of the property.
- An 83(b) election is generally irrevocable once made.
- 83(b) elections should be filed by certified mail with return receipt requested as the burden is on the person filing the election to prove the timely filing of the election.
- Please consult with your financial or tax adviser if you have questions regarding how an 83(b) election will impact you.
A Practical Example of an 83(b) Election
Imagine that an employee or a founder gets 500,000 shares of a company, but he or she receives these shares over a four-year vesting period, with 25 percent of the shares vesting on the first four anniversaries of the issuance date, in exchange for their services. If an 83(b) election is filed, then the fair market value of all 500,000 shares is treated as compensation income to the founder or employee at the time of grant
However, if the 83(b) election is not filed, then the first 25% or 125,000 shares vest after one year, and ordinary income would be recognized, if the value of the shares have significantly increased in that year and over the next four years, then the difference in tax can be substantial.
For the purpose of this example, let’s assume the shares have a value of $0.02 when granted, $0.50 at the end of year one, $1 at the end of year two, $2 at the end of year three, $3 at the end of year four, and the ordinary tax rate is 35%.
- If the employee or founder timely makes an 83(b) election, then he or she will pay ordinary income tax on $10,000 ($0.02/share * 500,000 shares) at grant, and the total ordinary income tax owed is $3,500 (35% * $10,000)
- However, if the election is not made, then the total taxes paid is a whopping $284,375 in ordinary income tax on the receipt of the shares:
When and How to File for an 83(b) Election
You must file for an 83(b) election within 30 days of your receipt of the restricted stock or stock option exercise. The 30 days is measured by the date on which your election is mailed to the local IRS office in your area. When the 30-day deadline falls on a weekend or holiday, the deadline extends to the next business day.
83(b) elections should be filed by certified mail with return receipt requested as the burden is on the person filing the election to prove the timely filing of the election.
There is no official form to make an 83(b) election. Some companies have created their own forms that you can use, but many companies do not provide this type of resource. Instead, the IRS recommends that you provide some specific language to make the election that would satisfy the IRS requirements.
If you want more information about how to make the 83(b) election or have questions about the election’s impact on your taxes and finances, send us an email at info@zagmoutcpas.com, or call us at (312) 239-3716.
To learn more, visit Zagmout & Company CPAs at www.zagmoutcpas.com.
