Reducing the Tax Impact of Equity Compensation: The 83(b) Election
April 19, 2022 Author: Tess Downing, MBA, CFP®, Complete View Financial
Employees or company founders that receive equity compensation often must cope with complex tax rules. Utilizing the 83(b) election is a valuable method of reducing tax liabilities, though there are some important caveats.
In this piece, we break down what it is and what you can do about it.
What Is the 83(b) Election?
The 83(b) election is a set of regulations under the Internal Revenue Code (IRC) that enables an employee, or startup founder, to be taxed on the total fair market value of restricted stock or options when they are granted rather than later upon vesting by sending a letter to the IRS.
Restricted shares are unregistered shares of ownership in a corporation issued to corporate affiliates, such as executives and directors. Along with the value of restricted stock, you can include the spread of your options in your election, i.e., the difference between the strike price — the options’ exercise price — and the shares’ fair market value when exercising them.1 To make the election, your shares must be subject to a considerable risk of forfeiture before vesting; for example, if you would lose the shares by moving to another company before the shares are vested.
The advantage of the election is the ability to pay taxes on the restricted shares earlier, hopefully before the stock price appreciates. Section 83(b) elections only apply to stock subject to vesting because grants of fully vested stock will be taxed when granted.
The grant date refers to when the company gives an employee company stock or a stock option award. Vesting is defined as when an employee has achieved ownership of company shares or stock options, usually by working for a certain number of years at the company, often five years.
An 83(b) election allows the employee to pay income taxes earlier, often before the company shares have climbed in value. Thus, when you sell shares for a gain later on (at least a year), you will pay capital gains tax instead of ordinary income tax, which is taxed at a higher rate. Another advantage of filing an 83(b): You start the holding period earlier, just after the grant date, so any capital gains accrued will probably be eligible for the capital gains tax rate.
However, if the value of the company shares declines after you made the 83(b) election, you may end up paying more in taxes than necessary because you prepaid the taxes when the company shares were worth more.
How Does it Work?
The 83(b) election documents must be sent to the IRS within 30 days after the restricted shares are issued. For options, the election must be made within 30 days of exercise. However, you should confirm that your employer’s plan permits you to exercise options before vesting. The recipient of the equity options must also present a copy of the completed election form to their employer.
The employee completes and signs an IRS Section 83(b) form or letter that includes the following information:
Personal information (name, address, Social Security number).
Description of the number and type of shares of which company, along with the date received or purchased, any restrictions your shares are subject to and the fair market value of the shares on the date received or purchased. Restrictions include forfeit if employment ends before vesting.
The amount paid for the company shares.
The amount the employee will record as gross income on their income tax return
Who Can Benefit?
Stock Option Holders
If you can exercise your stock options early (before vesting), you can file an 83(b) election. Doing so can potentially reduce your future tax liability if your company’s share price performs well.
Startup Founders and Key Employees
In some corporations, particularly startups, company founders or owners may receive a significant number of restricted stock shares as part of their overall compensation. Restricted shares are subject to specific rules, such as vesting and/or forfeiture (losing shares if you leave the company).
Key employees may also earn many restricted shares that could rise in value from the time of the grant to vesting. For founders and key employees, using the 83(b) election provides the opportunity to save by shifting the tax treatment of their shares from ordinary income taxes to capital gains taxes.
Let’s say a co-founder of a company is granted 1 million shares subject to vesting that are valued at $1 per share at the time of the grant. If the co-founder makes an 83(b) election, they will pay tax on the value of the shares upon issuance of the grant, i.e., the tax assessment will be made on $1 million only.
In the reverse scenario, if the employee filed an 83(b) election and the stock price falls when their investments vest, or the company files for bankruptcy, then the employee ends up overpaying the taxes—they paid taxes on shares with a higher value than the current fair value. The IRS does not allow you to file an overpayment of taxes under the 83(b) election—no do-overs are possible.
Another example when an 83(b) election is not beneficial is if an employee exits a company before the end of the vesting period. In this scenario, they paid taxes when the shares or options were granted, but they will not receive the shares.
A Section 83(b) election is a letter you send to the Internal Revenue Service instructing them that you want to be taxed on your shares of restricted stock on the date the shares were granted to you rather than when they vest. The 83(b) rules are straightforward, but you may need to consult your individual tax advisor.
Once the decision is made, the filing must be completed and arrive at the IRS within 30 days after the grant date of your restricted stock; this is an absolute deadline. The grant date of your restricted stock is usually the date the corporate board approves the grant. Thus, you may receive the paperwork a few days after that, so you may have to work quickly to decide about the 83(b) and file the correct paperwork.
1 Herman, Jeffrey and Frank, Adam. Stock-based Compensation and 83(b). J.P. Morgan Wealth Management