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?
- Potential Drawbacks of an 83(b) Election
- Do All Types of Equity Qualify for an 83(b) Election?
- Strategies to Minimize Risks and Maximize Benefits
- How to File an 83(b) Election Form
- Frequently Asked Questions (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 to 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.
Potential Drawbacks 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.
Do All Types of Equity Qualify for an 83(b) Election?
Not all forms of equity are eligible for an 83(b) Election, and it’s crucial to consult a Harness 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 Units (RSUs): An 83(b) Election cannot be applied to RSUs as they have no value until they 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. Specifically in the case of Incentive Stock Options (ISOs), an 83(b) Election may be beneficial, as it could help minimize any resulting Alternative Minimum Tax (AMT).
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 Harness Tax Advisor or other tax professional to file an 83(b) Election form with the IRS:
- Fill out an 83(b) Election form, which can be found on the IRS website or obtained from your employer, your Harness Tax Advisor, or a tax professional.
- Mail in the completed form via certified mail with a return receipt to the IRS within 30 days of receiving the shares. Inquire about the appropriate IRS address for filing the 83(b) Election, as it may vary 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.
- Notify your employer about your 83(b) Election and provide them with a copy of the completed form.
The IRS 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 no later than 30 days after the date of the grant. Failure to meet the 83(b) Election deadline may result in the loss of potential tax benefits associated with the election.
Frequently Asked Questions (FAQs)
- 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.
- 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. Unfortunately, you cannot claim a refund for taxes paid on those shares under an 83(b) Election.
- 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 Wealth Can Help
As with any major financial decision, it’s crucial to consult a Harness Tax Advisor or other tax professional when considering an 83(b) Election. At Harness Wealth, our Tax Advisors are experienced in well-versed in 83(b) Elections and other equity compensation matters. Our experts 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 with a Harness Tax Advisor 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.
