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As a startup founder, managing taxes on your equity is crucial. This is where the option to file an 83(b) election comes into play. It is an important notification that states your preference to be taxed on your equity, such as stock options or restricted stock units, at the time of grant rather than when it vests.
However, it's important to understand that 83(b) elections only apply to stock that vests over time, as fully vested stock grants are taxed immediately upon receipt. The primary benefit of making an 83(b) election is the potential for significant tax savings. By electing to pay taxes upfront, you could lock in a lower tax rate. This helps you avoid higher taxes in the future if the stock's value increases.
This blog covers the concept of the 83(b) election, its benefits, tax implications and how to file an 83(b) election.
The 83(b) election is a provision under the US Internal Revenue Code (IRC) that gives you the opportunity to pay taxes on the total fair market value (FMV) of your stock options or restricted stock units at the time of grant, rather than when they vest.
This becomes particularly important when you consider a typical four-year vesting schedule, during which the value of your equity could increase significantly. By the time you can exercise your equity, you might owe higher taxes due to the increased value. However, some companies allow early exercise of equity, i.e., before it vests and while the value is still low, which could result in potential future tax savings.
In this case, you must submit a written statement to the Internal Revenue Service (IRS) within 30 days of the date of the stock grant to file an 83(b) election. The election is irrevocable and must be filed even if the stock is not transferable or subject to a substantial risk of forfeiture.
Suppose you are granted 1,000 options at a startup. The FMV of each share at the time of granting is $30.
Scenario 1: When You File an 83(b) Election
The FMV of each share at the time of granting is $30. If you file an 83(b) election, you'll pay taxes on the total FMV of the stocks at the time of granting, which amounts to $30,000 (1,000 shares * $30 per share). If your tax rate is 37%, you'll owe $11,100 in taxes.
Fast forward to four years later, let's assume each share is now worth $100. Even though the total value of your stocks is now $100,000 (1,000 shares * $100 per share), you won't owe any additional taxes because you filed an 83(b) election. When you eventually sell the shares, you'll only owe capital gains tax on the difference between the $100 per share value at the time of sale and the $30 per share value that you were taxed on when you made the 83(b) election.
Scenario 2: When You Don’t File an 83(b) Election
On the other hand, you only have to pay taxes when exercising your stock options (ISO/NSO) - taxed as ordinary income for NSO and at AMT rates for ISO. The tax is based on the difference between the exercise price (the price you pay to buy the shares) and the FMV at the time of exercise. If the stock price increases between the time the options are granted and the time you exercise them, you will owe more in taxes.
For instance (assuming NSO), if each share is worth $100 at the time you exercise your options four years after they were granted, but the exercise price is still $30 per share. The difference of $70 per share ($100 FMV - $30 exercise price) is taxed as ordinary income. In this scenario, with 1,000 shares and a 37% tax rate, you owe $25,900 in taxes.
Hence, by filing an 83(b) election at the time of grant when the FMV was lower, you could have saved around $14,800 in taxes.
For Restricted Stock Awards (RSAs), the taxation process is different. RSAs are taxed at the time of vesting, not at the time of grant or exercise. The taxable income is determined by the FMV of the shares at the time they vest. If the shares increase in value from the time of grant to the time of vesting, the taxable income will be higher.
Filing an 83(b) election can offer several advantages, especially when founders expect their company's value to appreciate significantly. Here are some of the main benefits:
Locking in a Lower Tax Rate: By paying taxes upfront on a lower stock price, you can convert future appreciation into capital gains. They are subject to a favorable tax treatment compared to ordinary income.
Starting the Holding Period for Long-Term Capital Gains Earlier: By filing an 83(b) election, you can begin the holding period for long-term capital gains treatment right away.
Potential Reduction in Total Taxes Paid: If the stock value rises considerably in the future, filing an 83(b) election could result in lower overall taxes on the stock compared to being taxed at vesting. This is because you pay taxes based on the lower Fair Market Value (FMV) at the time of the grant.
Aligning with Startup Valuations: Startups often experience rapid growth and valuation increases. By filing an 83(b) election early in the lifecycle of the company, you can save on taxes as the company grows and the value of the stock increases.
While filing an 83(b) election can be beneficial, it's essential for you to be aware of the challenges that come with this tax strategy. You may face the challenge of having to pay taxes upfront on the FMV of the stock, regardless of whether its value decreases or if the stock is forfeited.
Once you make the election, you lose the flexibility to revoke it without obtaining consent from the IRS, adding a layer of permanence to your decision. There is also the potential challenge of Alternative Minimum Tax (AMT) implications, especially concerning incentive stock options, which could impact your tax liability.
Considering an 83(b) election is crucial for individuals in specific situations. Startup employees who receive equity compensation, especially those with restricted stocks subject to vesting, are ideal candidates for this election. Similarly, founders who receive company shares as part of their compensation package can also benefit from filing an 83(b) election to optimize their tax situation.
Opting for an 83(b) election offers a level of predictability in tax obligations. By paying taxes upfront, individuals can have a clearer understanding of their tax liability, aiding in long-term financial planning. Additionally, individuals with a relatively low income when they receive equity compensation may find filing an 83(b) election advantageous. This approach allows them to pay taxes based on the initial stock value, potentially avoiding higher taxes when the stock vests at a higher value.
When you file an 83(b) election, it has different implications for Incentive Stock Options (ISOs) compared to Non-Qualified Stock Options (NSOs). Understanding these differences is crucial when deciding whether to make an 83(b) election.
If you hold ISOs, filing an 83(b) election is generally not beneficial. This is because ISOs are not taxed when granted, upon vesting, or when exercised. Taxes are only due when you sell the shares, and if you meet certain holding requirements, you'll only pay capital gains taxes at a potentially lower rate.
However, there is one scenario where an 83(b) election could be advantageous for ISOs. If you expect the value of your company's stock to increase significantly, making an 83(b) election and paying taxes upfront on the lower current value could result in lower overall taxes when you eventually sell the shares. But this is a risky option, as you would be paying taxes on shares that may decrease in value.
For NSOs, filing an 83(b) election can provide significant tax benefits. With NSOs, the difference between the exercise price and the FMV at the time of exercise is taxed as ordinary income. By making an 83(b) election, you can pay taxes on this difference at the lower current value, rather than a potentially higher value when the shares vest.
For example, if you exercise 1,000 NSO shares at $1 each when they are worth $5 each, you need to pay ordinary income tax on the $4,000 spread. If you file an 83(b) election, you will pay taxes on this $4,000 upfront. If the shares appreciate to $100 each by the time they vest, you won't owe any additional taxes when they vest. This can result in substantial tax savings.
Restricted Stock Awards (RSAs) are a popular form of equity compensation. Here, a predetermined number of shares are granted, subject to a vesting schedule. At the time of grant, the shares are issued and held in escrow until they become available to the employee.
For RSAs, an 83(b) election can be beneficial. By filing an 83(b) election when receiving an RSA, the recipeint employee recognizes the initial value of the shares as ordinary income upfront. This helps with limiting their tax liability at that time.
A profits interest is an equity interest in the future appreciation of a partnership, or an LLC that is taxed as a partnership. It is sometimes described as an option, but there are key differences between them.
To prevent ordinary income tax on the initial value of a profit interest, you can opt for an election under Section 83(b) within 30 days of acquiring the interest. This election means paying taxes on the initial value of the profit interest, which is frequently minimal or even zero.
The election statement needs to be submitted to the IRS within 30 days of obtaining the stock. The process varies based on whether you hold restricted stock awards or stock options. If you miss this deadline, you will likely have missed the opportunity to take advantage of the potential tax benefits of the 83(b) election.
Not submitting a Section 83(b) election on time results in taxes being owed on restricted stock grants at each vesting date. As a founder, you are likely to face ordinary income tax rates on the stock's value exceeding the purchase price at vesting. This can result in a significantly higher tax obligation.
To file an 83(b) election, you must provide the following information to the IRS:
Here are the detailed steps for filing an 83(b) election:
1. Gather the necessary information: Collect all the required details, including your name, address, Tax Identification Number (TIN), and specifics about the restricted stock or profits interest you received.
2. Determine the Fair Market Value (FMV): Establish the FMV of the property at the time of transfer, taking into account any applicable restrictions.
3. Prepare the written statement: Draft a written statement containing all the required information, including your intention to make an 83(b) election. The statement should include a description of the property for which you’re making the election, the date of the transfer, and the taxable year for which the election is being made.
4. File with the IRS: Send the written statement to the IRS Service Center, where you file your tax returns. This must be done within 30 days of the grant date. You should send the form via certified mail to ensure it reaches the IRS.
5. Provide a copy to the company: Submit a copy of the completed election form to the employer. This helps the company maintain accurate records.
6. Keep records: Retain a copy of the 83(b) election for your records, along with proof of timely filing. You will need to attach a copy of the 83(b) election form to your tax return in the year you receive the stock.
If you fail to submit your 83(b) election form within 30 days after the grant date, then you will be required to pay federal taxes on stock awards at each vesting date.
Your gross income will be subject to ordinary income tax on the gap between the stock's value on the vesting date and the purchase price. This could result in a significantly higher tax liability when the stock value appreciates over the vesting period.
To file an 83(b) election, you need to complete the IRS 83(b) form and mail it to the IRS within 30 days of the grant. You must ensure that you send it to the relevant IRS Service Center, where you file your taxes. After mailing the completed form to the IRS, you should also mail a copy of the completed form to the company.
The IRS does not typically acknowledge receipt or send any correspondence regarding the filing. However, you can attempt to get confirmation by calling the IRS. It is recommended that you send the 83(b) election through USPS Certified Mail to receive a mailing receipt, which can be retained as proof that you have made the filing.
As discussed above, by making an 83(b) election you could potentially lock in a lower tax rate and avoid higher taxes in the future when the stocks appreciate. You also gain a degree of tax certainty that is useful for long-term financial planning.
However, 83(b) election is not suitable for everyone and carries risks like overpaying taxes if the stock value decreases or losing unvested shares on leaving the company. At Qapita, we understand the complexities of equity management and the need to make informed financial decisions.
Trusted by over 2,400+ companies and with a total of $55B+ equity under management, Qapita is a market leader in providing equity management solutions to global businesses. Our equity management platform helps companies digitally manage their CapTables and ESOP programs.
We are here to provide personalized advice and services regarding 83(b) elections and other equity management needs. Book a free consultation with our tax experts.
