83(b) Election Explained – When You Should Use It
Stock options and restricted stock units are a great way to build wealth over time. Unfortunately, stock compensation is taxable and if the stock price is rapidly appreciating, you can end up owing a pretty big tax bill when your stock vests. One way to potentially limit this tax liability is by taking a Section 83(b) election. Depending on the circumstances, this election can either help you or hurt you at tax time though, so it’s important to understand your options.
A Little Background
In order to understand how the 83(b) election works, you first need to know a bit about restricted stock. Restricted stock is an increasingly common way for companies, especially startups, to incentivize their employees to stay long-term and to tie the economic success of their employees to the performance of the overall business.
Let’s say, for example, that your friend Bob is starting a new business. You want to join his team, but Bob can’t yet afford to pay you what you need to make. To solve the problem, Bob agrees to give you a small salary and 50,000 shares of stock in the company, but he restricts the stock. In order to become fully vested in and achieve true ownership of the stock, you have to stay with the new company for three years. You agree, stay the full three years and get your stock.
This is all well and good but it’s important to remember that you do have to pay taxes on all of your compensation, even the part of it that is in the form of restricted stock. The stock you receive is considered income, and the Internal Revenue Service taxes it as ordinary income. The day you become vested in the stock, you owe the IRS income tax based on the stock’s fair market value.
If and when you sell the stock later, you’ll have to pay short or long term capital gains tax on your profit, depending on how long you keep the stock after the vesting day. But that’s a story for a different day (or blog article).
What Is the 83(b) Election?
Now let’s go back to the beginning. On your first day of work, Bob gives you your stock with the caveat that you have to stay with him for three years. Under current IRS rules, you now have 30 days from the day you are granted the stock to file an 83 b election with the IRS (completely at your discretion).
If you choose to file this election, you agree to pay income tax on the fair market value of your stock options right now (in this tax year) rather than waiting for three years until you actually take full ownership of the stock. In other words, you agree to a bigger tax liability today in exchange for a smaller tax liability in the future.
When You Should File an 83(b) Election
Let’s walk through a mathematical example to better understand when an 83(b) election might benefit you. Pretend that the 50,000 shares Bob gives you on your first day are worth $1 each and all of the stock is subject to a 3-year vest (i.e. it fully vests in year 3 but you have no vesting until then). If you elect the 83(b) and choose to pay the tax now, you’ll pay ordinary income tax on $50,000.
Now let’s pretend that you didn’t file an 83(b). The three-year holding period has passed and you’re now fully vested in the stock and own it outright. Bob’s company did well, and the stock is now worth $4 a share. That means you now have to pay tax on the full $200,000 of vested stock in year 3! That 83 b exemption you didn’t take is looking pretty good right about now, isn’t it?
Based on the above, it should be pretty clear that filing a Section 83(b) election can save you a lot of money if your stock is subject to a vesting schedule and you expect the stock price to appreciate meaningfully over the course of that vesting period. If this describes your situation, you should definitely look into an 83(b) election shortly after you receive your new job offer.
Note that may also wish to pay the tax on your shares now while you have a clear view of your financial situation. Nobody knows what the future will hold. If you know you have the money to cover your tax liability now but have concerns about your financial future, it may be best for you to get your tax bill out of the way sooner rather than later.
Coordinating the stock payment and 83(b) with your tax plan is smart, too. Perhaps earlier this year you made a sizable charitable contribution. Then you started working for Bob. The combination of your contribution and other tax deductions may help offset the tax you’ll pay on your stock, making the 83(b) a smart choice.
When Not to File an 83(b) Election
Although it can offer some significant tax savings, there are times when skipping the 83(b) election makes sense. One is if you expect your shares to decrease in value during their holding period. Perhaps you are joining a later stage company that just went public. The IPO went well but as often happens with IPOs, you believe that the stock was buoyed by the optimism often associated with public offerings. You think that the market will correct and the share price will drop. In this scenario, it’s smart to stay the course without the election.
Another reason to skip the 83 b is when you don’t plan on meeting the vestment terms. Let’s say you didn’t really want the job that Bob offered you. You appreciated the offer since you were between jobs at the time, but you’re hoping to find a better job and leave Bob’s company before the three years pass. In this case you’re very unlikely to ever receive your stock, so there is no point in paying tax on it now.
Finally, you may want to skip the election if the Fair Market Value of your restricted stock is pretty high ($300k+). In this scenario, filing the election may put you into a higher tax bracket than you otherwise would be in and your effective tax rate would be much higher than you’d like in year 1. In this scenario, tax savings in future years are unlikely to offset the higher taxes you’re paying in year 1.
It’s important to remember that no matter what decision you make, there are no guarantees. You can choose when to pay the tax on your shares, but both choices contain some inherent risk that the stock price will do the opposite of what you expect.
Instructions for Filing a Section 83(b) Election
In order to utilize the 83(b), you must file a form with the IRS. The form is simply called the “Election under Code Section 83(b).” This election form is formatted as a letter and you simply fill in the blanks. The form asks you to specify that you received stock, report the date of receipt and the fair market value of the stock at that time. You’ll also need to report the restrictions put on the stock, telling the IRS what goals you must reach to become fully vested.
Once complete, you’ll want to make four copies of the form. You need to send the original election form to the IRS. You will mail the form to the same place that you mail your personal income taxes. Send the form certified mail with a return receipt — the burden of proving you filled the form lies with you.
You’re also required to give a copy of the form to the company giving you the stock, and you’ll want to keep a copy for yourself. Some states may also require a copy.
You’ll include the final copy with your tax return when you file. At tax time, you’ll simply add the value of your shares to your tax return. They should appear on the Form W-2 your employer gives you, making it easy to file. You need not do anything special except including a copy of your 83(b) form.
Taking the 83(b) means taking a chance, and it can be difficult to choose your best option without a crystal ball. We here at Picnic Tax don’t have a crystal ball, either. What we do have is years of professional tax experience that can prove helpful when weighing your options. Sign up today and we’ll help you decide if this special stock exception is right for you. If it is, we can help you file it now so you’re ready come tax time.