What Is An 83(b) Election?
An 83(b) election is a provision of the federal tax code that permits a recipient of restricted stock (typically a founder or employee of a startup company) to pay income tax on the value of the stock when it is initially granted, rather than when the stock is actually received by them, which can be years later and at a much higher value.
How the IRS Section 83(b) Election Works
Young companies sometimes pay employees and service providers in restricted stock, which is considered compensation by the IRS and is taxed at fair market value. Typically, these shares are subject to a vesting period while work or services are being rendered.
This means that, while the shares may be granted to an individual when hired, the recipient won't actually receive the shares until they vest, which might occur over a two-to-three-year period or more. In addition, vesting plans may require that the recipient has adequately performed the services for which they are receiving the stock.
With a vesting plan, there is a “substantial risk of forfeiture” since a recipient may leave the company or the business may dissolve before the employee is fully vested. As a consequence of this risk, the normal tax treatment for restricted shares is for them to be taxed as ordinary income when they vest (i.e. when they become the property of the recipient).
This might seem like the IRS is doing RSU holders a favor. If an individual was granted stock on a three-year vesting plan, one-third of the shares would vest after the first year, another third after the second year, and the final third after the third year. The income tax on the shares is due as they are received.
But here’s the rub. When initially granted, such shares usually carry a very low value and, as the company grows and takes on investment capital, the shares can considerably appreciate. Thus, it is likely that when one receives shares in accordance with the vesting plan, they will be worth more and the tax will be commensurately higher.
Recognizing this, the tax law makes accommodation to recipients of restricted stock by allowing them the option to pay taxes on the fair market value of such stock at the time of the grant. A one-page tax filing called an 83(b) election is what individuals use to take advantage of this tax option.
Whether taking an 83(b) election or not, restricted shareholders will eventually be subject to capital gains (or losses) when they ultimately sell the shares on the sale value less the value when received. Given that long-term capital gains tax rates are generally lower than ordinary income tax rates, paying tax on capital gains is generally preferable to paying ordinary income tax on the same amount.
Key Takeaway: An 83(b) election enables an individual to pay income tax on restricted shares when they are likely to be at their cheapest value and then pay capital gains taxes on any appreciated value when the shares are ultimately sold.
Who Can File an 83(b)?
An 83(b) election can be made by any individual who receives stock as compensation, subject to a vesting period. If there is no vesting period, the individual would have no other option than to pay income tax on the value of the stock when received.
RSU 83(b) Election Example
Let’s assume Frank is an early employee at a startup and receives a grant of 30,000 restricted stock units (RSUs) with a three-year vesting plan. That would provide Frank with 10,000 shares at the end of each of the next three years. At the time of the grant, the units have a par value of $0.05 per share.
Let’s further assume the shares are later valued at the following prices:
- After 1 year: $0.60 per share
- After 2 years: $1.50 per share
- After 3 years: $3.00 per share
We will also assume Frank’s incremental tax rates during the period are:
- Ordinary income: 32% tax rate
- Long-term capital gains: 15% tax rate
Frank’s scenario would look like this:
Normal income tax due
Tax due with 83(b) election
$0 (No shares received)
(30,000) * (.05) * .32 = $480
End of Year 1
(10,000) * (.6) * (.32) = $1,920
End of Year 2
(10,000) * (1.5) * (.32) = $4,800
End of Year 3
(10,000) * (3.0) * (.32) = $9,600
Total tax due
Cost basis of shares
Frank’s out-of-pocket income tax would clearly be a lot less under an 83(b) election. This, however, is only part of the story. The cost basis of Frank’s shares will also be lower under the 83(b) election. That means his capital gain when he sells the stock will be greater. So, the result of taking an 83(b) election is lower income tax when the stock is received, but higher capital gains tax when the shares are sold.
This still makes the 83(b) election worth considering, since the up-front savings will more than make up for the higher capital gains tax later, as long as capital gains rates remain lower than ordinary income rates. In addition, the bulk of the tax liability is put off for as long as the shares are held and wouldn’t be due until the shares are liquidated.
Pros & Cons of an 83(b) Election
- Saves on income tax: Can save on total taxes due for receipt of restricted stock shares
- Defers tax: Avoids paying the bulk of taxes due on shares until they are sold.
- Helps with cash flow: Avoids the burden of paying a lot of income tax on assets you cannot sell right away
- Requires tax payment be made before even receiving the shares: The 83(b) election requires the tax payment be made in the year when shares are granted rather than received.
- Taxes may be paid on assets you never receive or which eventually become worthless: An 83(b) election can potentially result in taxes being paid on shares forfeited if you leave the employer before being vested or shares that eventually become worthless if the company folds.
83(b) Election on Non-Qualified Stock Options
It is possible to use an 83(b) election for receipt of non-qualified stock options, though it may depend on whether the provisions of those options allow for it.
In addition, valuing options at the time of grant can be a rather thorny issue. Non-traded stock can be valued at par value or at the last value determined by a capital raise. Neither of those valuation methods works for options and if the option’s exercise price is higher than where the stock is currently valued, they may not have any tangible value at all.
Tip: Filing an 83(b) election for a stock option grant would thus be a matter specific to the situation and should be discussed with a tax or investment advisor.
When To File an 83(b)
An 83(b) election must be filed with the IRS within 30 days of receipt of the stock grant.
How To File an 83(b) Election Form
An 83(b) election is filed by sending the appropriate form to the Internal Revenue Service. It should be filed by certified mail with a return receipt requested to ensure that the form is filed in a timely manner.
Note: An 83(b) election is generally irrevocable once made.
An 83(b) election can potentially save a considerable amount of tax on the receipt of stock as compensation when there is a vesting period involved. The election effectively enables the recipient to pay income tax on the value of the shares when granted rather than when they are received through the vesting arrangement and would likely be valued quite a bit higher.
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