A timely and correctly filed 83b election can lead to significant tax savings, especially for early-stage companies where the value of shares is expected to appreciate substantially over time.
The 83b election allows you to pay taxes on stock options or restricted stock awards (RSAs) at the time of grant or early exercise rather than waiting until vesting, which could result in lower tax liability if the value increases significantly.
What Is an 83b Election?
An 83b election is a filing with the IRS that allows you to be taxed on eligible shares at the time of the grant or early exercise, instead of when the shares vest. By electing this treatment, you pay taxes on the shares before you have full ownership. Doing so can reduce the amount of ordinary income recognized, as the spread between the cost of the shares and their fair market value (FMV) may be much lower at the time of the 83b filing than at vesting.
Additionally, the holding period for long-term capital gains tax purposes starts from the date of the 83b election, not the vesting date, meaning you could qualify for lower long-term capital gains rates sooner.
Risks of Filing an 83b Election
An 83b election can be beneficial, but it also carries two significant risks:
- Capital loss on sale: If you end up selling the shares for less than your cost basis, the loss is considered a capital loss, which can only be used to offset future capital gains or $3,000 of ordinary income per year (if single or married filing jointly).
- Forfeiture of shares: If the shares are forfeited (for example, if you leave the company before vesting), your deduction is limited to the amount you actually paid for the shares (i.e., your cost basis), not the previously recognized ordinary income. The taxes paid at the time of the 83b election can’t be recovered.
Impact of 83b Election on Different Types of Equity Compensation
Non-Qualified Stock Options (NSOs or NQSOs)
NSOs Without Early Exercise or 83b Election
At the time of grant, there’s no tax implication. When options vest and you exercise, the spread (the difference between FMV at exercise and the exercise price) is taxed as ordinary income and subject to withholding. If you sell shares at a gain later, the difference between the sale price and FMV at exercise is taxed as capital gains (short-term or long-term depending on holding period).
NSOs With Early Exercise and 83b Election
If you early exercise your NSOs (before they vest), you can file an 83b election to be taxed on the spread between the exercise price and FMV at exercise. Doing so can result in little to no taxable income if the exercise price and FMV are similar. After filing the 83b, there’s no additional tax at vesting, as you already paid taxes at exercise. When you sell the shares at a gain after holding them for at least a year, capital gains tax rates apply to the difference between the sale price and the FMV on the exercise date.
When Should You File an 83b Election for NSOs?
Consider an 83b election if you’re confident the stock will appreciate, you plan to stay at the company long enough for vesting or you expect an exit event (e.g., IPO or acquisition) within a year of vesting.
When Should You Not File an 83b Election for NSOs?
Reasons to not file an 83b election for NSOs include:
- Risk of forfeiture: If you may leave the company before the shares vest, you could lose the tax benefits and only get a limited tax deduction based on your cost.
- Risk of loss: If the stock’s value decreases, you won’t be able to claim the loss until you sell, and it will be subject to capital loss limitations.
- A large, upfront tax bill: If you need to borrow money to exercise early for tax benefits, it might not be worth the financial strain.
Incentive Stock Options (ISOs)
ISOs allow for tax-deferral until the shares are sold, provided the holding period requirements are met (two years from grant, one year from exercise). However, the spread (FMV at exercise minus the exercise price) is subject to alternative minimum tax (AMT), which can trigger a higher tax bill.
ISOs With Early Exercise and 83b Election
By early exercising your ISOs and filing an 83b, you could potentially reduce your AMT liability, because the income recognition is accelerated. You won’t trigger regular income tax at exercise, but the spread will still be considered for AMT purposes, potentially resulting in a significant AMT bill if the spread is large.
Should You Convert ISOs to NSOs?
If you plan to sell ISO shares within two years from grant or one year from exercise, they’ll be subject to ordinary income tax. Converting to NSOs could avoid this, as you’d only pay tax on the gain when you sell the shares, and it could be treated as either short-term or long-term capital gains, depending on the holding period.
When Does It Make Sense to Exercise ISOs Early and File an 83b Election?
Filing an 83b election for ISOs can help reduce AMT exposure if you anticipate being in AMT when you exercise at vesting. However, if you’re not likely to trigger AMT, it might not be worth filing the 83b, as it would generate AMT income without offering the tax benefits of regular income tax.
Restricted Stock Awards (RSAs)
RSAs Without an 83b Election
If you receive RSAs as part of your compensation, there’s no tax due at grant. At vesting, the spread (FMV on vesting minus purchase price) is taxable as ordinary income and subject to withholding. Your cost basis in the shares is the FMV on the vesting date. When you sell, the growth from the vesting price to the sale price is eligible for long-term capital gains tax if held for at least a year after vesting.
RSAs With an 83b Election
If you file an 83b election within 30 days of the RSAs grant, you pay taxes on the spread at the time of the grant. This amount is treated as ordinary income and subject to withholding. The cost basis becomes the FMV on the grant date, and no additional tax is due at vesting. When you sell the shares, any gain from the FMV at grant to the sale price is taxed as long-term capital gains after holding for a year.
When Should You File an 83b Election for RSAs
Filing an 83b election for RSAs may be beneficial if you anticipate the shares could potentially appreciate and you plan to stay with the company until vesting. If there’s a high risk of forfeiture or decline in value, or if the upfront tax payment is a burden, it might be better to avoid filing the 83b election.
The 83b election can potentially offer tax benefits, especially for early-stage company stock options or RSAs that may appreciate. However, this strategy involves risks, including the possibility of paying taxes on shares that might be forfeited or lose value. It’s important to carefully evaluate your situation, including your confidence in the company’s future, your employment status and your ability to cover the upfront tax bill before deciding whether an 83b election is the right choice for you. Always consult with a qualified professional before making this decision to ensure you understand the potential financial implications.
Could you use help implementing an 83b election? Creative Planning is here for you. Our tax advisors work alongside your wealth manager to help ensure your tax planning strategies remain on track. Our teams have experience navigating a wide range of tax and financial challenges, always with a goal of lowering your tax liabilities and helping you achieve your long-term goals.
