Section 83(b) Election: A Tax Mitigation Strategy
for Startup Owners and Employees
Section 83(b) of the Internal Revenue Code (IRC) allows employees and other service providers to elect to be taxed on the fair market value of restricted stock or stock options at the time they are granted, rather than when they vest. This can be a valuable tax planning strategy for employees of startup companies, as it can help to defer taxes until the stock has appreciated in value.
How does 83(b) work?
When an employee is granted restricted stock or stock options, they are not taxed until the stock vests. This means that the employee can sell the stock or exercise the options without having to pay taxes on the appreciation in value, as long as the stock has not vested.
However, if the employee makes an 83(b) election, they will be taxed on the fair market value of the restricted stock or stock options at the time they are granted. This means that the employee will have to pay taxes on the appreciation in value, even if the stock has not vested.
When should you make an 83(b) election?
Making an 83(b) election is a personal decision that should be made on a case-by-case basis. However, there are a few factors that you should consider when making your decision:
In each of the below examples, assume you receive 100,000 shares subject to vesting, worth $.01 per share at the time of grant, $1.00 per share at the time of vesting, and $5.00 per share when sold more than one year later. We’ll also assume you are subject to the maximum ordinary income tax rate and long-term capital gains rate. For simplicity, we will not discuss employment tax or state tax consequences.
In this example you timely file a Section 83(b) election within 30 days of the restricted stock grant, when your shares are worth $1,000. You pay ordinary income tax of $370 (i.e., $1,000 x 37%). Because you filed a Section 83(b) election, you do not have to pay tax when the stock vests, only on the sale. On the sale (which occurs more than one year after the date of grant) you recognize a taxable gain of $4.99 per share (not $5.00, because you get credit for the $.01 per share you already took into income), and pay additional tax of $99,800 (i.e., $499,000 x 20%). Your economic gain after tax? $399,830 (i.e., $500,000 minus $370 minus $99,800).
In this example you do not file a Section 83(b) election. So, you pay no tax at grant (because the shares are unvested), but instead recognize income of $100,000 when the shares vest and thus have ordinary income tax of $37,000. On the sale (which occurs more than one year after the date of vesting) you recognize a taxable gain of $4.00 per share (not $5.00, because you get credit for the $1.00 per share you already took into income), and pay additional tax of $80,000 (i.e., $400,000 x 20%). Your economic gain after tax? $383,000 (i.e., $500,000 minus $37,000 minus $80,000).
So, in the above example, filing a Section 83(b) election would have saved you $16,830.
Please note that the election must be filed with the IRS within 30 days of the date of your restricted stock grant. Failure to file within that time will render the election void and you may recognize ordinary taxable income as your vesting restrictions lapse.
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The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.