83(b) Election

The 83(b) election is a provision of 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, as opposed to the time of vesting. Named after Section 83(b) of the IRC, this election can significantly affect the tax obligations of individuals who receive equity compensation. Understanding the 83(b) election is crucial for those involved in startups or early-stage companies, where equity is often a key component of compensation packages.

What is the 83(b) Election?

Under typical circumstances, when an employee receives restricted stock, they are taxed as the stock vests. The value of the stock is considered ordinary income, and it is taxed at the current fair market value. However, with an 83(b) election, the taxpayer can choose to be taxed on the value of the stock at the time it is granted, even if it has not yet vested.

The Importance of Fair Market Value

The fair market value (FMV) plays a central role in the 83(b) election. The FMV is the price that the stock would sell for on the open market. By paying taxes on the FMV at the time of grant, an individual can potentially save money if the company’s stock appreciates significantly before it vests. The main objective is to lock in the current lower value for tax purposes, in the hope that the stock will increase in value by the time it vests, thus avoiding higher taxes later.

How Does the 83(b) Election Work?

Steps to File an 83(b) Election

1. Notification: The initial step involves notifying the IRS of your intent to make the 83(b) election. This must be done within 30 days of the stock grant.
2. Letter Submission: You must send a letter to the IRS that includes information such as your name, address, social security number, and details of the stock grant.
3. Employee’s Copy: A copy of this letter should be provided to the employer.
4. Save a Copy: Always keep a copy for your personal records.

Below is a sample of the information that could be included in the 83(b) election letter:

Pursuant to Section 83(b) of the Internal [Revenue](../r/revenue.html) Code, the undersigned hereby elects to include in [gross income](../g/gross_income.html) the excess, if any, of the fair [market value](../m/market_value.html) of the property described below over the amount paid for such property.

1. The [taxpayer](../t/taxpayer.html)'s name, address, and [social security](../s/social_security.html) number.
2. A description of the property with respect to which the election is being made.
3. The date on which the property was transferred and the taxable year for which such election is being made.
4. The nature of the restriction to which the property is subject.
5. The fair [market value](../m/market_value.html) at the time of transfer.
6. The amount paid for the property.
7. Any other information required by the Treasury Regulations applicable to the tax year in which the property was transferred.

Dated: [date]

Example Calculation

Imagine an employee named Jane receives 1,000 shares of her company’s restricted stock when the FMV is $1 per share. Without an 83(b) election, she’ll be taxed on the FMV of the stock as it vests. Suppose it vests at $5 per share in the future; she would owe taxes on $5,000 (1,000 shares x $5).

If Jane decides to file an 83(b) election, she’ll pay taxes on the $1,000 value now (1,000 shares x $1), regardless of the future FMV when the stock vests. This could result in a lower tax obligation.

Risks and Benefits

The 83(b) election is not without risks, and weighing the benefits against potential downsides is essential.

Benefits

• Tax Savings: By paying taxes on the current lower value, potential tax savings can be significant if the stock appreciates.
• Capital Gains: Future appreciation can be taxed at the lower long-term capital gains rate instead of the higher ordinary income rate.

Risks

• Loss of Value: If the stock’s value decreases, you might end up paying more in taxes than you would have without the election.
• Forfeiture: If you leave the company before the stock vests, you cannot recover the taxes already paid.
• Cash Flow: Paying taxes upfront can impact cash flow, especially for startup employees who might not have the liquid resources to pay these taxes.

Practical Considerations

Consulting with an Expert

Because of the complexities and potential risks involved, consulting with a tax advisor or financial planner is strongly recommended. They can help evaluate whether an 83(b) election is the right choice based on individual circumstances, anticipated stock growth, and overall financial plans.

Employer Policies

Understanding employer-specific policies is also crucial. Some companies might have specific instructions or additional requirements for making an 83(b) election. Always check with the employer’s HR or stock plan administrator to ensure compliance.

IRS Complications

Mistakes in filing the election or late submissions can result in missed opportunities and potential penalties. Ensuring that the filing is correct and timely is imperative.

Current Trends and Technological Support

Technological Tools

Several technological tools and platforms now offer assistance with filing 83(b) elections. These may include automated filing services, tax calculators, and software to track equity compensation. Popular platforms like Carta (https://carta.com/) and Shareworks by Morgan Stanley (https://www.shareworks.com/) provide comprehensive equity management solutions that can facilitate the process.

Increasing Awareness

There has been a growing awareness of the 83(b) election among startup communities and tech companies. Workshops, webinars, and online resources are increasingly available to help employees and founders understand the implications.

Case Studies

Example 1: Tech Startup

In a tech startup scenario, a programmer named Alex receives 5,000 shares at a $1 FMV per share when joining the company. He files an 83(b) election and pays taxes on the $1 per share. Five years later, when the stock vests, the shares are worth $20 each. Without the 83(b) election, Alex would owe taxes on $100,000 (5,000 shares x $20). By electing 83(b), he avoided a high tax rate on the appreciable value.

Example 2: Pharmaceutical Company

Nevertheless, not all scenarios turn out positive. Consider a case in a pharmaceutical startup where an employee named Sara files an 83(b) election for 2,000 shares with a $5 FMV per share, paying taxes on $10,000. If the drug fails and the stock plummets to $1 per share by vesting time, Sara ends up overpaying in taxes since the stock depreciated.

Conclusion

The 83(b) election is a powerful tool that can lead to significant tax savings, particularly in high-growth scenarios typical of startups. However, the decision to file an 83(b) election should never be taken lightly. Potential risks must be considered, and specialized tax advice is crucial. Understanding the financial landscape, the company’s potential, and personal circumstances will inform whether the 83(b) election is beneficial.