Navigating the complexities of equity compensation can be challenging – especially for company founders who may receive significant amounts of stock. One critical decision you may face is whether to file an 83(b) election for certain equity grants. Taking advantage of this important Internal Revenue Code provision can yield significant federal tax savings by allowing you to pay federal taxes on the value of your equity awards when they’re granted, which may be significantly lower than what it will be later. However, the election also comes with risks you’ll want to consider.
Here are simple answers to questions you may have about 83(b) elections.
What is an 83(b) election?
An 83(b) election is a provision under the Internal Revenue Code that allows you to choose to be taxed on the value of certain equity awards, such as restricted stock, at the time of grant (i.e., when the company officially awards you the equity compensation), rather than at the time of vesting (when you gain full ownership rights to the shares). You may also file an 83(b) election if you early-exercise stock options and receive restricted stock that remains subject to vesting; in this scenario, you choose to be taxed on the value of the shares as of the date of exercise.
Note, the 83(b) election must be filed with the Internal Revenue Service within 30 days of the grant or exercise, and it applies to both private and public company stock. You must also provide a copy of your 83(b) election to your company.
Why consider an 83(b) election?
The main advantage of an 83(b) election is to potentially lower your overall federal tax liability by locking in the current value of the equity award at grant (or exercise, in the case of early-exercised options). If you believe your company’s stock will appreciate significantly in the future, paying federal taxes on the current value, which can be nominal, can potentially result in substantial tax savings.
Additionally, once the stock has potentially increased in value after vesting, any gain on the sale of the stock is taxed at the more favorable federal long-term capital gains rate (if held for more than a year), rather than as ordinary income.
How can an 83(b) election affect my tax bill?
The potential tax impact of an 83(b) election can vary in different circumstances, but consider one hypothetical example: A founder, Sarah, is granted 10,000 non-qualified stock options (NQSOs) with an exercise price of $1.00 each.
- Scenario A: Sarah does not file an 83(b) election. Four years later, her business has grown substantially. She exercises the vested options, paying $10,000, and sells all of her shares at a fair market value of $11.00 each, resulting in a gain of $100,000 (i.e., $110,000 in sale proceeds, minus her $10,000 exercise price), which is treated as ordinary income. Assuming Sarah’s federal income tax rate is 37%, with a 2.35% Medicare tax,1 the sale could potentially trigger a $39,350 federal tax liability.2
- Scenario B: Alternatively, Sarah early-exercises all of her options at grant and receives restricted stock, paying $10,000 for the shares,3 and files an 83(b) election within 30 days of exercising. In this example, the shares’ fair market value at early exercise is $1.00, which is the same as the exercise price; thus, the taxable “spread” is zero, so Sarah initially pays no upfront federal taxes. After four years, she sells the shares at the higher fair market value of $11.00 each, resulting in a gain of $100,000, which is treated as a capital gain. In this case, assuming a 23.8% federal tax rate on the capital gains, the sale results in a potential $23,800 tax liability.2,3
In this example, making the 83(b) election leads to a potential $15,550 in tax savings.
What are the risks of an 83(b) election?
While the potential tax benefits are appealing, there are risks associated with an 83(b) election:
