A Section 83(b) election could be one of the biggest tax-saving decisions for taxpayers who receive equity subject to vesting. It is common for start-up founders and key employees to receive a standard “Restricted Stock Purchase Agreement” with a vesting schedule. Under this document, the company has the right to buy back these stocks if he or she is terminated or leaves the company. The 83(b) election is extremely useful and can result in great tax savings under this situation. Without an 83(b) election, a startup founder or key employees may end up with a large tax bill at a time when their stock is still illiquid. By selecting the election, ordinary tax rates (max 37%) on higher values at vesting periods can be prevented and will accelerate the holding period, which will allow for any gain at sale or liquidation to more quickly be recognized as capital (max 20%). Capital assets are subject to the favorable taxable rate if held for a year or more.
What Is an 83(b) Election?
In general, if in connection with the performance of services, the taxpayer receives restricted property which is subject to a substantial risk of forfeiture, or which is non-transferable as compensation when received, the taxpayer doesn’t have to account for the fair market value (FMV) of that property as income until it is determined that the restrictions have been lifted and the property becomes transferable (IRC Section 83(b).
Section 83(b) provides an opportunity to elect to be taxed at the time of the receipt of the property (e.g., grant date) instead of waiting for the property to become transferable, or no longer subject to a substantial risk of forfeiture (e.g., vesting date). In simpler terms, rather than paying tax at each vesting period stated in the stock or equity agreement, tax can be paid on the date in which the shares were acquired. Section 83(b) elections are only applicable for equity that is subject to vesting.
The Advantages of Election 83(b)
There are numerous advantages to filing an 83(b) election. Section 83(b) accelerates the determination of taxable income to the date the equity was granted or purchased instead of on the date(s) the equity vests. The holding date begins on the date of grant, rather than the vesting date, which generally triggers capital gain (20%) treatment at the date of sale or liquidation one year later.
Without the 83(b) election, the taxpayer pays tax on the paper value of the stock as it vests. If the stock vests during a period of “hyper growth,” the taxpayer will pay “hyper taxes.” This is because the amount subject to tax is the difference between the FMV of the stock on the vesting date and the purchase price at the grant date, and will be taxed as ordinary income with a max rate of 37%. On the other hand, with an 83(b) election, the taxpayer will be taxed on the value of the stock on the day the stock is granted. As the FMV of stocks is generally nominal at the grant date, the total tax on the stock will be nominal. In addition, the election accelerates the holding period, which allows for any gain at sale or liquidation to more quickly be recognized as capital (max 20%).
The Disadvantages of Election 83(b)
There are risks involved in making the 83(b) election. For instance, if the equity value drops during the holding period, the taxpayer has essentially paid tax on unrealized income. The taxpayer pays the ordinary tax at the grant date, which is higher than the market value at the vesting date(s), leading to a higher tax consequence. Election 83(b) does not make sense if the taxpayer foresees low growth prospects for the equity, as that could lead to decreases in value. Also, if the equity value at the grant date is substantial, then the taxpayer might be subject to a higher tax sooner under the 83(b) election.
Example of 83(b) Election
Assume a taxpayer receives 1,000 shares subject to vesting and pays nothing for them. The shares are worth $1 per share at the time of grant, $5 per share at the time of vesting, and $10 when the stock is sold three years after vesting. At the date of grant, the taxable income will be $370 ($1,000*37%). Because the Section 83(b) election has been filed, the taxpayer does not pay tax when the stock vests, only on the sale date. When the stock is sold three years after vesting, the taxpayer recognizes a capital gain of $9 per share ($10, less the $1 tax basis of the stock). The tax on the date of sale will be $1,800 ($9,000*20%). The total tax at the grant date and sale date is $2,170.
Let’s look at the same scenario, but without the 83(b) election. The taxpayer will pay no tax on the grant date. The tax at the vesting date will be $1,850 ($5000*37%). When the taxpayer sells the stock, the taxpayer recognizes a capital gain of $5 per share ($10, less the $5 tax basis of the stock). The tax on the sale date will be $1,000 ($5,000*20%). The total tax is $2,850. The difference between the taxes paid—$2,170 with the 83(b) election, and $2,850 without—amounts to a difference of $680 (or an 31.3% increase) in tax savings for the taxpayer who makes the 83(b) election.
Taxpayers choosing to make an 83(b) election must do so quickly, as documentation must be filed with the IRS within 30 days after the grant or purchase date of the restricted stock. Every day—including weekends and holidays—is counted toward the 30-day window. If the thirtieth day falls on a weekend or holiday, the election will be considered timely if it is postmarked by the following business day. The taxpayer will need three copies of the election form—a copy to file with the IRS location where one normally files his/her tax return, one to deliver to the company or employer, and the third to retain for one’s personal, permanent records.
If you have questions about 83B election, credits and deductions, or tax filings, or would like to request a speaker on these topics for your organization or event, contact one of our PYA executives below at (800) 270-9629.