Key takeaways
|
Navigating equity compensation can be challenging, especially when it comes to understanding tax implications. One essential tax-saving tool for startup founders and employees dealing with equity compensation is the 83(b) election. In this guide, we will provide you with a detailed understanding of the 83(b) election, including its benefits, potential risks, and the filing process, including:
Table of contents
- What is an 83(b) Election and How Does it Work?
- When is the Right Time for an 83(b) Election?
- The IRS 30-Day Filing Deadline For an 83(b) Election
- What are the Risks of an 83(b) Election?
- What Types of Equity Qualify for an 83(b) Election?
- Strategies to Minimize Risks and Maximize Benefits
- How to File an 83(b) Election Form
- 83(b) Election FAQs
What is an 83(b) Election and How Does it Work?
The 83(b) election is a provision under Section 83(b) of the Internal Revenue Code that allows startup founders or employees who receive equity compensation to choose to pay taxes on the fair market value of their shares when granted, rather than when they vest. This can be advantageous if you anticipate a significant increase in the value of your shares or startup as a whole, and it could potentially result in tremendous tax savings if and when you sell your shares.
For example, let’s say a startup grants an employee 100,000 shares of restricted stock at $1 per share. If the fair market value of the shares increases to $5 per share by the time the stock fully vests, the employee would normally need to pay taxes on the difference between the initial grant price and the fair market value at the time of vesting, which would be $400,000. However, if the employee had made an 83(b) election and paid taxes on the initial grant price of $100,000, they would only need to pay taxes on the difference between the initial grant price and the sale price of the stock, resulting in a tax bill of just $35,000 upon vesting, and $140,000 in savings.
See the chart below for a more visual representation of this example:
Example impact of 83(b) election |
||
| 83(b) election | Without an 83(b) election | |
| Number of RSs issued | 100,000 | 100,000 |
| Taxable event | At time of RS grant | At time of RS vesting |
| FMV per share at time of grant | $1.00 | $1.00 |
| FMV per share at time of vesting | $5.00 | $5.00 |
| FMV of all shares at time of taxable event | $100,000 | $500,000 |
| Taxes paid at taxable event (35% ordinary income tax rate) | $35,000 | $175,000 |
When is the Right Time for an 83(b) Election?
Many factors go into any major financial decision, but here are just a few considerations when evaluating if an 83(b) election might make sense for you:
- Anticipated growth in share value: If you believe the value of your shares will significantly increase over time, an 83(b) election may help you lock in a heavily-reduced tax bill.
- Long-term investment horizon: If you plan to hold your shares for an extended period, making an 83(b) election could be beneficial. Holding your shares for at least one year from the date of the 83(b) election and two years from the grant date may qualify you for long-term capital gains tax treatment, which generally has a lower tax rate than ordinary income.
If you think filing an 83(b) election is the right choice for your situation, it’s important to make sure you file within the IRS’s 30-day window of your grant date or exercising your options.
The IRS 30-Day Filing Deadline For an 83(b) Election
The deadline for filing an 83(b) election is crucial. The election statement must be filed with the IRS within 30 days of acquiring the stock, which is different depending on whether you have restricted stock awards or stock options.
- For restricted stock awards, the 83(b) election statement must be filed within 30 days of receipt of the shares, also known as the grant date. It’s important to note that if you wait to file until the vesting date, you will likely have missed the deadline, as your vesting date is usually later than your grant date.
- For stock options, the 83(b) election must be filed within 30 days of exercising your options. Remember to confirm with your employer that your plan allows you to exercise options before they vest.
Failure to meet the 83(b) election deadline may result in the loss of potential tax benefits associated with the election.
What are the Risks of an 83(b) Election
While making an 83(b) Election can be advantageous, there are also potential risks and drawbacks to consider, including:
- Upfront tax payment: You must pay taxes based on the current fair market value of your shares, even if they may be worth less or become worthless in the future. This means you could potentially pay taxes on shares that may never provide any positive return on investment, and it will of course require some upfront capital.
- No tax refunds on vested shares: If your shares decrease in value or are forfeited (i.e., due to termination of employment before the shares fully vest), you cannot claim a refund on the taxes paid. This can result in a financial loss, as you’ve paid taxes on shares that are no longer in your possession or have declined in value.
- Limited applicability: The 83(b) Election is not applicable to all forms of equity compensation, such as Incentive Stock Options (ISOs). It’s crucial to understand which types of equity awards can benefit from an 83(b) Election and which cannot.
What Types of Equity Qualify for an 83(b) Election?
Not all forms of equity are eligible for an 83(b) election. It’s crucial to consult a tax advisor or other tax professional when considering an 83(b) election in order to fully evaluate your specific situation and potential tax implications.
Restricted Stock Awards (RSAs)
When RSAs are granted, the employee immediately becomes a shareholder with voting rights in the company, subject to a vesting schedule, and certain restrictions. RSAs are taxed at the time they vest, with the fair market value of the shares on the vesting date treated as ordinary income. By filing for an 83(b) election, an employee can pay taxes on the total fair market value of the shares at the time of grant, rather than waiting for the shares to vest. This can lower an employee’s tax bill if the value of the shares increases significantly over the vesting period.
Restricted Stock Units (RSUs)
It’s important to not confuse RSAs with RSUs, as an 83(b) election cannot be applied to RSUs because they have no value until they vest. If employees are granted RSUs, that do not become shareholders until the RSUs fully vest. When RSUs do vest, they are taxed as ordinary income.
Stock Options
An 83(b) election is not applicable to stock options themselves but may apply to shares acquired upon exercising the options early. It’s important to verify with your employer that you can exercise your stock options early. There are differences between Incentive Stock Options and Non-Qualified Stock Options when filing an 83(b) election
- Incentive Stock Options (ISOs): With ISOs, when you file an 83(b) election, the spread between the fair market value and your exercise price is included as income for the Alternative Minimum Tax (AMT). If you do not file an 83(b) election, you may be required to pay AMT on the spread between the strike price and the fair market value as you continue to vest, instead of the spread at early exercise which could potentially trigger the AMT or lead to a higher AMT.
- Non-Qualified Stock Options (NSOs): With NSOs, the spread between the fair market value and your exercise price is treated as income for ordinary income tax purposes. If you choose not to file an 83(b) election, you’ll be subject to a higher income tax rate if the fair market value of your shares increases over the time that your options vest.
83(b) Election for Profits Interest in an LLC or Partnership
Profits Interest represents a right to the future profits of an LLC or Partnership without an upfront ownership stake or value. Unlike restricted stock, profits interest typically has no tangible value at the time of grant, as it’s based on future growth. By making an 83(b) election, the employee opts to recognize any income from the profits interest at the grant date. Given that profits interest usually has zero initial value, this can result in little to no tax liability at the time of an 83(b) election. Without an 83(b) election, taxes would be due as the profits interest vests, based on the potentially higher value at a future date.
Strategies to Minimize Risks and Maximize Benefits
To minimize the risks associated with an 83(b) election and optimize your tax savings, consider the following strategies:
- Time your election wisely: If you have a choice regarding the timing of your equity grant, consider making the election when the fair market value is as close to your exercise as possible, as this will help minimize your tax liability.
- Understand your vesting schedule: Familiarize yourself with your employer’s vesting schedule. Not all employers issue shares at the same frequency.
- Consider long-term capital gains: Holding your shares for at least one year from the date of the 83(b) Election and two years from the grant date may qualify you for long-term capital gains tax treatment, which generally has a lower tax rate than ordinary income or short-term capital gains tax.
How to File an 83(b) Election Form: A Step-by-Step Guide
Follow these steps and work with a tax advisor or other tax professional to file an 83(b) election form with the IRS:
- Complete an 83(b) election form. Unlike other IRS tax forms, there is not an official 83(b) election form provided by the IRS. You can choose to use a template from the IRS website, from your employer, your tax advisor, or you can create your own using the free Harness template, making sure to include the following information:
- Your name, address, and Social Security number
- The property subject to your election (ex: # shares of common stock of ABC company)
- The date you received the property and the tax year for the election (ex: the grant date of your RSAs)
- Any restrictions the property is subject to (ex: shares are forfeited if the employee leaves the company before vesting)
- The fair market value of the property on the date received
- The amount you paid for the property which could be $0
- A statement that you have provided copies of the 83(b) election form to the IRS and your employer
- Notify your employer about your 83(b) election and provide them with a copy of the completed form.
- Mail in the completed form to the IRS via certified mail with a return receipt within 30 days of receiving the shares. Address it to the IRS Service Center where you file your taxes. Ask your tax professional about the appropriate IRS address for filing the 83(b) election, as it varies depending on your location. The certified mail with the return receipt will help you confirm that the IRS received the 83(b) form.
- Keep a copy of the completed form, the return receipt, and the mailing envelope with the 83(b) filing address for your records.
Sample 83(b) Election Form
There is not an official 83(b) election form. Various templates can be used, either created by a tax advisor or a company, or self-created with the necessary information.
To save you time, download the free Harness 83(b) election form template.
The following is a sample 83(b) election form template provided by the IRS:
83(b) Election FAQs
Is there an 83b election form?
There is no official IRS form specifically designated for the 83(b) election. Instead, individuals must create their own written statement to make the election. This statement must include specific information as outlined by the IRS and must be filed within 30 days of receiving the restricted stock or equity interest.
What happens if you don’t file an 83(b) election?
If you don’t file an 83(b) election after receiving restricted stock or certain types of equity in a company, you forego the option to pay taxes on the fair market value of the equity at the time of grant. You will be subject to taxes as the equity vests, based on the market value of the equity at each vesting date. If the value of the equity increases between the time of the grant and the vesting dates, you could end up paying more in taxes than if you had made an 83(b) election.
What if I miss the 83(b) election deadline?
If you miss the 30-day deadline for filing an 83(b) Election, you will not be able to take advantage of the potential tax benefits. You will be taxed on the fair market value of your shares as they vest.
Can you file 83(b) election electronically?
The IRS allows for electronic signatures (e-sign) on 83(b) election forms but does not allow the form to be filed electronically. If you e-sign an 83(b) election form, you still must mail a copy to the IRS Service Center where you file your taxes and provide a copy of the form to your employer.
What happens if I leave the company before my shares fully vest?
If you leave the company before your shares fully vest, any unvested shares will likely be forfeited, and you cannot claim a refund for taxes paid on those shares under an 83(b) election.
How is the 83(b) election reported on my W-2?
When you make an 83(b) election for your restricted stock or other equity compensation, the income from this election is included with all other ordinary income on your W-2 in box 1. If you do not receive a W-2, 83(b) election income may also be reported on a 1099-NEC.
How do I report an 83b election on Form 1040?
To report an 83(b) election on your taxes using Form 1040, you will enter the value that was included on your W-2 in box 1, or on your Form 1099-NEC. Additionally, the IRS no longer requires you to include your 83(b) election form when filing your taxes.
Can an 83(b) election be revoked?
An 83(b) election is irrevocable without the consent of the IRS. Revoking an 83(b) election is rare and generally only granted under exceptional circumstances.
Harness Can Help With An 83(b) Election
As with any major financial decision, it’s crucial to consult a tax advisor or other tax professional when considering an 83(b) election. At Harness, we connect you to tax advisors well-versed in 83(b) elections and other equity compensation matters. Your advisor can guide you through the entire process, from determining whether an 83(b) election is right for you, to ensuring timely and accurate filing and maximizing tax savings.
If you have equity compensation and are wondering if an 83(b) election is right for you, book a one-hour Equity Tax Planning today.
Tax services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is an internet investment adviser registered with the Securities and Exchange Commission (“SEC”). Harness Wealth Advisers LLC solely acts as a paid promoter for unaffiliated registered investment advisers. Harness Wealth Advisers LLC’s registration as an investment adviser with the SEC does not imply a certain level of skill or training.
