The 83(b) election is an essential tax planning tool for individuals who receive equity in a company, especially in startups. It can provide significant tax savings if exercised correctly. In this article, we’ll explain the concept of the 83(b) election, its benefits, potential risks, and present two examples to illustrate its application.
What is an 83(b) Election?
The 83(b) election is a provision in the Internal Revenue Code (IRC) that allows employees or founders who receive restricted stock or other forms of equity compensation to pay income taxes on the fair market value (FMV) of the equity at the time of grant, rather than when the restrictions on the equity lapse.
Generally, when an individual receives equity in a company, they are taxed when the equity vests. Vesting is the process by which an employee gains full ownership of the equity over a specified period. However, with an 83(b) election, the individual chooses to pay taxes upfront based on the FMV at the time of grant, which can lead to significant tax savings if the value of the equity appreciates over time.
Benefits of the 83(b) Election
• Lower Tax Liability: Since the 83(b) election allows individuals to pay taxes on the FMV of the equity at the time of grant, they can potentially pay a lower tax rate than if they waited until the equity vested. This can be especially beneficial if the company’s value increases significantly over time.
• Capital Gains Treatment: By making an 83(b) election, any future appreciation of the equity is treated as a capital gain, rather than ordinary income. Capital gains are typically taxed at a lower rate than ordinary income, resulting in further tax savings.
Potential Risks of the 83(b) Election
1. Loss of Investment: The most significant risk associated with the 83(b) election is that the individual pays taxes upfront, and if the company fails or the value of the equity decreases, there is no possibility of recovering the taxes paid.
2. Tax Payment Timing: An 83(b) election must be made within 30 days of receiving the equity. Failure to do so will result in the individual being unable to take advantage of the 83(b) election and being taxed when the equity vests.
Examples of the 83(b) Election
Example 1: Startup Founder
John is a founder of a startup and receives 1,000,000 shares of restricted stock, which have a current FMV of $0.01 per share. The shares are subject to a 4-year vesting schedule with a 1-year cliff. John decides to make an 83(b) election. He pays taxes on the FMV of the shares at the time of grant, which is $10,000 (1,000,000 shares x $0.01).
Over the next four years, the company’s value increases, and the shares’ FMV rises to $2 per share. When John’s shares vest, the total value is $2,000,000. However, since he made the 83(b) election, John only pays taxes on the $10,000 FMV at the time of grant, avoiding taxes on the $1,990,000 appreciation.
Example 2: Employee with Stock Options
Mary is an employee of a tech company and is granted 10,000 stock options with a 4-year vesting schedule. The FMV of each share is $20, and the exercise price is $15. Mary decides to exercise her options and make an 83(b) election. She pays taxes on the FMV minus the exercise price, which is $50,000 [(10,000 shares x ($20 – $15)].
Over the next four years, the company’s value increases, and the shares’ FMV rises to $50 per share. When Mary’s shares vest, the total value is $500,000. However, since she made the 83(b) election, Mary only pays taxes on the $50,000 FMV minus the exercise price at the time of grant, avoiding taxes on the $300,000 appreciation.
The 83(b) election can be a valuable tax strategy for individuals who receive equity in a company. By paying taxes upfront based on the FMV at the time of grant, individuals can potentially benefit from a lower tax liability and capital gains treatment for future appreciation. However, it’s essential to weigh the potential risks, including the possibility of a loss of investment and the strict timing requirements for making the election. Consulting with a tax professional is highly recommended to understand the best course of action for individual circumstances.
This article was written by chat.openai.com and was edited for accuracy by Daniel J. Rohr, CPA/PFS, EA, M.S. Tax.