While this question may not rise to the level of gravity contemplated by Hamlet in his famous Shakespearian soliloquy, it nonetheless should be given serious consideration by anyone in a position to make such an election. The 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.
The 83(b) election is not appropriate for everyone. But under the right set of circumstances, it can provide a tremendous tax saving strategy. Let’s raise the curtain and take a closer look.
Section 83(b) of the Internal Revenue Code permits the taxpayer to file an election to report income tax on his or her equity, including shares of restricted stock, in the tax year that it is granted, instead of waiting until it vests. Keep in mind that this election is only available for stock that has not fully vested, is not yet transferrable, and retains a significant possibility of forfeiture. If your stock has fully vested, the 83(b) election would not be an option.
In making an 83(b) election, you are electing to be taxed (at ordinary income tax rates) on your shares when they are granted, with the possibility that you will receive a lower long-term capital gains tax treatment upon sale of these shares in the future (assuming they are held for at least one year from the grant date).
Consider the following example:
Let’s say you are awarded 1,000 shares of restricted stock from your employer. We’ll also assume the share price at that time is $10/share. In most circumstances, if you do not file an 83(b) election, you would not have an immediate tax liability when these shares are granted. However, in our example, each year 250 shares vest for the next four years. This means you will incur a tax liability on the value of those vested shares at that time. For instance, if the share price is $15/share on the first vesting date, the total vested value would be $3,750 (250 x $15). If you are in a 24% federal income tax bracket, you would owe $900 in federal income taxes. In year two, as another 250 shares vest, the stock price has climbed to $20/share and your tax bill would be another $1,200. At the end of year three, the stock price has reached $25/share and your tax bill will be $1,500. At the end of year four, when the stock price hits $30/share, you would owe a final tax bill of $1,800, for a grand total of $5,400 over the four-year vesting period.
Using that same example, had you made an 83(b) election as those initial restricted stock shares were granted, you would have immediately paid the federal income tax due on the entire award. In this case, 1,000 shares multiplied by $10/share would equal $10,000. Assuming you were in a 24% tax bracket, you would have paid $2,400 in taxes, rather than $5,400 if you had waited to pay it over time as your shares vested. As you can see, if you have the means to pay the income tax liability up front, you would be much better off financially to file the 83(b) election (based on the assumptions of this hypothetical scenario).
As mentioned, one of the advantages of making an 83(b) election is that it establishes the starting point for your holding period, allowing preferred long-term capital gains tax treatment to begin one year from the earlier grant date rather than one year from the vesting date. In the scenario described above, you would be able to sell your shares and incur only a 15% long-term capital gains tax on any growth achieved since the grant date, assuming you had filed a timely 83(b) election and waited at least one year prior to selling your shares. Had you not filed the election, you would need to wait for at least one year after each of the 250 share allotments vested, before you could take advantage of the long-term capital gains rates. The 83(b) election would allow you to access these shares sooner rather than later with beneficial tax treatment.
Additionally, it allows you to control the timing of your tax liability. If you have the ability to pay the taxes now, you can avoid being subject to them as your shares automatically vest at certain points in the future. Not knowing what life has in store, you might not be in a position to pay those taxes down the road.
Keep in mind that you must file the 83(b) election with the Internal Revenue Service within thirty days after your restricted shares are issued, otherwise you will be deemed to have waived your election. This could be a costly mistake if you aren’t prepared to take action in a timely manner.
In those cases where the value of the restricted shares you receive is insignificant, which is often the case in start-up companies, you will have little to lose. Under those circumstances, filing an 83(b) election would be worthy of consideration. However, there are several scenarios where filing this election would ultimately be disadvantageous. Keep in mind that filing an 83(b) election means you are paying taxes for shares you haven’t received, with the expectation that these shares will increase in value over time. If the value of your stock decreases before it vests, or even worse, if your company fails prior to your vesting date, you will have paid more than necessary in taxes for those shares.
Another scenario where it would not be beneficial to make the election would be if you were to leave or be terminated from your company prior to the vesting date. Because the decision to make an 83(b) election is considered irrevocable, once it is made, you should not expect to receive a refund for overpayment of taxes. Therefore, one must not only consider the outlook for the stock price but also the outlook for one’s continued employment with the company when contemplating whether or not to make such an election.
As you can see, there are a number of variables that come into play regarding the 83(b) election. Given you will only have a short period of time to make a one-time, irrevocable decision, don’t get caught off-guard. With the guidance of an experienced financial professional, you’ll better understand your options and be prepared to make a fully-informed decision.
Bob Harris, J.D., CFP®
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.