The 83(b) Election: Saving Taxes on Your Equity Compensation
- Company founders and those working for growing companies can potentially minimize their long-term tax liability through an 83(b) election
- Restricted stock and Non-Qualified Stock Options benefit the most from this provision and tax strategy
- There are important rules to know and risks to consider with an 83(b) election – working with an experienced team of advisors is critical to ensure you make the right moves
A critical aspect of tax management is knowing when to take advantage of the opportunity to pay tax at a potentially lower rate or on a lower asset base amount. For startup founders and early employees of a quickly growing company, the 83(b) election provision offers the chance to reduce your overall tax liability by periodically paying taxes on the total fair market value (FMV) of restricted stock, non-qualified stock options (NSOs), and incentive stock options (ISOs) on the grant date. According to the Internal Revenue Code, the 83(b) election applies to equity that is subject to vesting.
What Is an 83(b) Election?
An 83(b) election is actually a straightforward process. It’s also a tax-savvy way to manage equity compensation when taking a long-term perspective. A taxable event is triggered when you perform the election. While that sounds like a bad thing, it’s often the smart move since paying taxes sooner rather than later can mean a smaller amount of capital is taxed. If the value of the shares rises substantially between the grant date and vest date, then you would be subject to much more tax – this is when an 83(b) election can save startup employees vast sums.
An 83(b) Election with Restricted Stock
For example, let’s say your company is in its very early innings, and the value of your hypothetical 10,000 shares of restricted stock at $0.50 per share is $5,000 on the grant date and you are in the 35% tax bracket. We will assume all shares are vested. An 83(b) election locks in a $1,750 tax liability.
Years later, assume the company is a success with shares valued at $500, and your stake is $5 million. You then owe capital gains tax on $5 million less $5,000. At a 20% rate, that’s $999,000. Your total taxes paid between the pair of tax events is $1,000,750.
If you did not perform an 83(b) election, then total taxable income is simply the FMV at the vesting date multiplied by the number of vested shares. That’s $500 x 10,000 = $5 million. Applying the max 37% marginal tax rate, and you might owe $1.85 million.
So, the tax savings of the 83(b) election in this instance was $849,250.
Do I have your attention now? The impact of choosing to pay tax today saves thousands of dollars or more for many tech startup workers. There are key rules to follow, though. The IRS filing must be made within 30 days after the grant of restricted stock or the early exercise of stock options. Also important to know – restricted stock units (RSUs) are not eligible for an 83(b) election.
For employee stock options, an early exercise provision can be timed with performing an 83(b) election. With NSOs, you lock in your ordinary income tax liability and trigger the start of the holding period requirement for long-term capital gains eligibility.
Less Upside When Applied to ISOs
With ISOs, the election accelerates the taxable event for AMT purposes with the objective of minimizing overall AMT impact. It’s not to say that an 83(b) election is not an optimal move with ISOs, but the upside is likely smaller relative to restricted shares and NSOs. The 83(b) election does not accelerate the one-year holding period for determining a qualifying disposition when you sell ISOs and earn a better tax treatment. A stock sale must occur at least one year after the ISOs’ vesting date regardless of an early exercise and 83(b) election for a qualifying disposition.
An 83(b) Election with NSOs
Let’s run through another example: this time with NSOs. The early exercise provision allows you to take advantage of a relatively small price difference between the options’ exercise price and the FMV of the stock. Here are the details of the scenario:
- Number of NSOs: 50,000
- Exercise price: $1
- FMV at early exercise: $5
- FMV on the vest date when you exercise: $50
- FMV upon sale: $50
Without an 83(b) election, here’s the tax you would owe:
[($50 – $1) x 50,000] x 37% = $906,500
With an 83(b) election, the tax savings are once again big:
[($5 – $1) x 50,000] x 37% = $74,000
When shares are finally sold at $50, long-term capital gains tax is owed:
($2,500,000 – $250,000) x 20% = $450,000
Total tax paid with the 83(b) election: $524,000
Total tax savings comes to $382,500
In general, the 83(b) election is potentially a major tax savings if the current FMV of the stock is very low for restricted shares or if the stock is at or near the exercise price of NSOs. After performing an 83(b) election, if the stock rises substantially and all other holding period requirements are met, the appreciation would be taxed at long-term capital gains rates when you sell.
Recognize the Risks
There are potential downsides, though. If the value of the stock drops after you perform an 83(b), you might end up paying more in tax than the stock is worth. Also, if you ultimately sell shares at a loss, you will not be able to claim the loss for a capital loss deduction against your income due to the 83(b) election. It’s also possible that the stock drops between vest dates – then you would pay more tax than if you simply waited.
There are other situations to consider. For instance, if you leave the company before shares vest, then any shares you exercised early could be repurchased by the firm. On the positive side, if your company goes public or is bought at a high share price, then you’d be happy you did an 83(b) election early on. Finally, we want to underscore the importance of making your 83(b) election within 30 days of receiving restricted stock or within 30 days of exercising options – this is perhaps the most critical aspect to get right.
The Bottom Line
An 83(b) election can save tech employees vast amounts if they have a small value of shares or options today and expect the value of the company to rise dramatically over time. There are key rules to abide by to make the election work along with potential downside risks to weigh.
The team at Archer is here to help tech industry professionals make the most of their equity compensation. Knowing your options and navigating tax laws can be challenging, but we specialize in helping you make wise decisions that keep your financial plan on the best path.To find out if an 83(b) election makes sense for you, please click here to schedule a phone call and please visit us at Archer Investment Management.