If you’re in a place with equity compensation, you’ve probably encountered a ton of fancy terms and lingo that can leave you scratching your head. One term that’s important but often misunderstood is the “83(b) election.” This one’s crucial, especially if you’re holding restricted stock (not to be confused with RSUs) or stock options. Not understanding this election could mean shelling out way more in taxes than you need to.
In this post, we’ll break down:
- What an 83(b) election is
- How it works
- Why it is important
- When it may make sense to file one
- And how to file one
What Is A 83(b) election?
Let me start by explaining a few terms:
- Grant date: is the date on which a stock option or other equity-based award is granted to the recipient. Note, these will not become yours until they vest.
- Vest date: This is when they actually become yours. Or you can actually exercise these options and they become yours. Typically, you have to work somewhere a certain amount of time to get the shares.
- ISO’s = This stands for Incentive stock options. They are a type of equity comp where you have the right to buy these shares at the specific price you were granted.
- Restricted Stock = They are shares in a company issued to employees as part of their pay, but which cannot be fully transferred to them until certain conditions have been met.
Now that you know the main terms, let’s get into what an 83(b) election actually is.
It is a set of regulations under the Internal Revenue Code that allows founders, employees, etc. to be taxed on the fair market value of their options or restricted stock at the grant date vs the vesting date. Basically this just means you can choose to pay tax earlier, at the grant date (when they are granted to you) vs waiting years down the line to the vesting date. This can be a huge advantage for those at private companies where valuations are growing rapidly.
If valuations grow quickly, that means the difference between your exercise price and the market price may be very large leading to a huge tax bill. An 83(b) election lets you pay tax upfront vs waiting for this large difference that can be created over the years.
But… there is always a negative to this. You may think this growth will happen with your company, but if it ends up going the opposite way, then you prepaid tax at a higher amount than what it is actually worth. You do not want that to happen, but it is a risk that can and does happen.
How Does This Work For Different Types Of Equity?
When you receive restricted stock, you have two choices (notice I said restricted stock, not restricted stock units (RSU’s), they are two different things). You can either pay income tax when it’s granted and then long term capital gains rates when you sell (by doing 83(b) election) or you can pay ordinary income tax on the whole amount once it vests. The 83(b) election allows you to pay tax earlier on the (hopefully) smaller amount.
Incentive stock options (ISO) are the other main type you would use an 83(b) election for. How ISO’s work is that you when they vest you have no tax liability unless you trigger AMT (alternative minimum tax). This is a tax at 26% or 28% and can happen easily with ISO’s and a large gap between the exercise price and the market value. Using an 83(b) election allows you to have less ‘paper gain’ so you have less or even no AMT. However, you need to be able to early exercise for this to work. Not all companies allow for early exercise so check with HR.
Let’s say the co-founder of a company is granted 100,000 shares at $.10. This means the founder has $10,000 worth of shares. And let’s assume that this will vest over 4 years meaning he will get to exercise 25,000 shares a year, every year. Let’s also assume this company is new and has tons of growth potential. If the company’s equity grows to be worth $1 a share, then his $10,000 worth will now become $100,000 worth. In year 1, the founder’s tax liability will be ($25,000 since he only has 1/4 of the shares – $2,500). x .32% (tax bracket) = $7,200 of tax. And this is only in year 1. And again this is an example and assumes a fast growth.
Let’s say in year 2 they really take off and the shares are now worth $5. Now his tax liability in year 2 will be (25,000 x $5) = $125,000 – $2,500 (cost basis) = $122,500 x .32% (tax rate) = $39,200 of tax.
That is a lot of tax! You need to plan for this. If the value of the equity keeps climbing, the tax liability will also. His other option would have been to file an 83(b) election and early exercise and pay tax at 100,000 x .1 = $10,000 x .32% = $3,200. In this example, this would result in way less tax.
It’s also important to note that this is the tax for when they become his. Then when he sells he will also have tax at short term or long term capital gains rates based on how long he holds the investments for after they vest.
This is a perfect example of when an 83(b) election could make sense. If he were to do it and pay the taxes upfront before the vesting date, he could save a ton in taxes. Remember, the 83(b) election lets the IRS know that he wants to prepay the tax based on that initial dollar value he was given. The growth of the company over that time frame won’t matter and impact those taxes. Then he will also pay tax again when he sells at capital gains rates. It is a powerful tool to front load paying the tax when share prices are lower.
Times It Does Not Work Out Well
There are two scenarios where this will not work out well for you:
- The company’s value and stock value go down and you overpaid on tax
- You do not stay long enough for all the shares to vest. If you leave and do not get to exercise, you paid the tax but then own none of the shares. No one wants that! It is important to understand that if you early exercise, file your 83(b), and then leave your company before vesting, your company has the right to repurchase your unvested, early exercised shares at their original issued price. You will also not be able to recover the taxes paid on those unvested shares.
You need to make sure you plan to be there long enough for this to make sense. You do not want to pay tax on shares you never received.
How To File An 83(b) Election
Your next question probably is how do you file one? It is important to note that you have to file this 83(b) election within 30 days of the restricted shares being issued. For options, it must be made within 30 days of exercising your options early.
Here’s how you file:
- Complete a section 83(b) election letter
- Mail the letter to the IRS (has to be within 30 days). Make sure to mail to the IRS service center where you also send your tax return. Pro tip: always send the IRS two copies of the 83(b) election and a stamped, addressed return envelope. They will file stamp a copy and send it back for your records.
- Also mail a copy of the letter to your employer
- Make sure to retain these copies as proof as well as proof of the mailing
This stuff gets complex fast, so make sure you work with your CPA and financial planner on all of these moves before making any rash decisions.
If you need help with your equity comp planning, we are here! You can head on over to allstreetwealth.com and apply to work with us.