83(b) Election: Definition & When to File
The world of taxes can be complicated.
When a founder or an employee has access to stock options, they can either choose to pay taxes on them year by year at the ordinary income tax rate. Or they can pre-pay tax related to the current fair market value.
That’s where the 83(b) election comes into play.
Read on as we take a closer look at this provision.
Table of Contents
- The 83(b) election is a provision under the Internal Revenue Code.
- It applies to any equity that is subject to vesting.
- It gives either a startup founder or an employee the option to pre-pay tax. This is against the total fair market value of restricted shares of a stock.
- The price paid is the market value of the stock at the time it is granted.
What Is The 83(b) Election?
The 83(b) election is a provision that is under the Internal Revenue Code (IRC). It allows an employee or a startup founder to be given an option of paying taxes on the total fair market value of restricted stock. This would be at the time of grant. For employees, this is known as having employee stock options.
If an 83(b) election is filed before the stock has appreciated its strike price, then there will be no income. The strike price means that there is also no tax owed.
Who Might File An 83(b) Election And Why?
An 83(b) election would most likely be filed by either the founder of a company or an employee who has received compensation in the form of common stock.
This would mean that the person in question would pre-pay their tax liability on a lower valuation if the stock price begins to climb. However, if the stock value starts to decline over a time period, then the person in question would have essentially overpaid on taxes.
How And When To File 83(b) Elections
83(b) elections should be filed within 30 days of the stock being granted. They can be filed by completing an IRS Section 83(b) Election Form and mailing it to the IRS.
The steps are as follows:
- Complete the IRS 83(b) form.
- Mail the completed form to the IRS within 30 days of your grant date.
- Address the letter to the IRS Service Center where you file your income taxes.
- Mail a copy of the completed 83(b) form to your employer.
What Happens If An 83(b) Election Is Not Timely Filed?
When an 83(b) election is not timely filed, it will place a burden on the stockholder as well as the company. The company would need to figure out a new value for the newly vested shares at every vesting date. They would also need to properly report this newly decided amount as compensation.
83(b) Election Example
Let’s say that the co-founder of Company X is granted 100,000 shares subject to vesting. These shares are valued at $0.001 at the time the shares are issued. This would mean that the shares are worth the par value of $0.001 x 100,000 shares. This would equal $100 which the co-founder of Company X would pay.
These shares would represent a 10% ownership of the firm and will be vested over a period of time of five years. This means that they will receive 20,000 shares every year for 5 years. In each of these five vested years, they would need to pay the tax on the fair market value of the 20,000 shares vested.
If the total value of Company X’s equity increases to $10,000, then the co-founder’s 10% value increases from $100 to $1,000. The co-founder’s tax liability for Year 1 will be taken away as follows:
($1,000 – $100) x 20%
($10,000 – $1,000) x 10% x 20% = $180
- $10,000 is the value of the firm in Year 1
- $1,000 is the value of the firm at inception. This is otherwise known as the book value.
- 10% is the ownership stake of Company X’s co-founder
- 20% is the 5-year vesting period for the co-founder’s 100,000 shares
If in the second year the stock’s value increases to $50,000, then the co-founder’s tax would be as follows:
($50,000 – $1,000) x 10% x 20% = $980
By Year 3, the value doubles to $100,000. The tax liability would be assessed as follows:
($100,000 – $1,000) x 10% x 20% = $1,980
If the total value of this equity continues to climb through Year 4 and Year 5, then the co-founder’s further taxable income will increase alongside it for each of the years.
If the co-founder later decides to sell all of their shares for a profit, then they would be subject to a capital gains tax. This would be on the gain from the proceeds of selling the shares.
The Benefit Of An 83(b) Election
An 83(b) election means that you can pre-pay the tax liability on the total fair market value of the restricted stock at the time of granting. This is beneficial only if the value of the restricted stock increases over the following vested years.
If the amount of income reported is a smaller amount at the time of granting, then an 83(b) election could be beneficial.
Risks Of An 83(b) Election?
Filing this form can be a substantial risk. If an 83(b) election is filed with the IRS and the value of the equity falls, then the taxpayer overpaid in taxes for a share that has a small, or worthless amount. This can also happen if the company in question files for bankruptcy. The IRS doesn’t allow an overpayment claim of takes under the 83(b) election. Meaning there is no chance of a tax rebate.
Another substantial risk is if the employee leaves the company before the vesting period, or holding period, is over. This would mean that filing an 83(b) election would be disadvantageous as they would have paid taxes on shares that they will never receive. And if the amount of income reported is larger at the time of the stock options being granted, then filing for an 83(b) election wouldn’t make much sense.
An 83(b) election grants either founders or employees the chance to pay taxes on the total fair market value of restricted stock. This would be at the time that the stock was granted.
This method is somewhat of a gamble. If the share price of the common shares increases, then you will end up paying less tax for higher-value stock options. Meaning that over the vested period you will save money on taxes and experience long-term capital gain.
However, if the price of the stock decreases, then you will essentially be overpaying taxes on a stock that is either worth less, or worth nothing.
83(b) Election FAQs
An 83(b) election works by sending a letter to the IRS stating your desire to be taxed on your equity on the date it was granted to you Versus at the time it vests.
An 83(b) election doesn’t need to be filed for shares that are vested fully at the time they were issued. Or for stock options. The burden lies with the person who is filing the election. This is to prove the timely filing of the election. So they should be filed by certified mail or via mail with a return receipt.
83(b) elections should be reported automatically on your W2. It must be filed within 30 days of the equity being awarded. The IRS doesn’t require that a copy be filed with your income tax return.
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