What is the Section 83(b) Election Process?
The Section 83(b) Election Process can be a little tricky, so let’s start at the beginning.
Under Section 83(b) of the Internal Revenue Code (“Section 83(b)”), a taxpayer who receives certain property subject to vesting as compensation for services (for example, a restricted stock award granted by the taxpayer’s employer) may elect to include in gross income the fair market value of the property at the time of the transfer over the amount (if any) paid for the property (an “83(b) election”). If an 83(b) election is made, the taxpayer recognizes income on the property in the year of the transfer, rather than in a potentially later year when the property becomes vested.
In summary, a Section 83(b) election is a letter a taxpayer sends to the Internal Revenue Service (“IRS”) letting the IRS know you would like to be taxed on your shares of restricted stock on the date you were granted equity rather than on the date the equity vests. This issue comes up time and time again in stock option plans for startup companies or companies that recently had an initial public offering (“IPO”).
Section 83(b) elections are applicable to stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant.
This election allows you to be taxed at the preferential capital gains tax rate rather than the ordinary income rates.
This can be a major tax savings. The maximum ordinary income tax rate in 2016 is 39.6%, whereas the maximum long-term capital gains rate in 2016 is 20%. Because the United States uses a progressive system with graduated tax rates (meaning the rates vary based on your income), you may actually be subject to lower ordinary income rates, but if you make more than $37,650 in a year then the long-term capital gains rate will certainly be lower than the ordinary income tax rate.
Assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant (if a Section 83(b) election is filed), or at vesting (if no Section 83(b) election is filed), in each case at the applicable ordinary income tax rate.
In a startup company, this distinction can be a major tax savings for an individual because often the difference in the stock price between a few years can be substantial.
When you later sell your stock, assuming it’s been more than one year from the date of grant (if a Section 83(b) election is filed), or more than one year from the date of vesting (if no Section 83(b) election is filed), the additional gain will be taxed at the applicable long-term capital gains rate. Because the long-term capital gains rate will be lower, the goal here is to get as much of your gain as possible taxed using that rate, rather than the ordinary income tax rate. Thus, the earlier you file your 83(b) election, the more of the gain that can be shifted to long-term capital gains tax rates.
83(b) Election Examples
In each of the below examples, assume you receive 100,000 shares subject to vesting, worth $0.01 per share at the time of grant, $1.00 per share at the time of vesting, and $5.00 per share when sold more than one year later. We’ll also assume you are subject to the maximum ordinary income tax rate and long-term capital gains rate.
These Section 83(b) election process examples are right out of the treasury regulations promulgated by the IRS.
Example 1 – 83(b) Election:
In this example, you timely file a Section 83(b) election within 30 days of the restricted stock grant, when your shares are worth $1,000. You pay ordinary income tax of $396.00 (i.e., $1,000 x 39.6%). Because you filed a Section 83(b) election, you do not have to pay tax when the stock vests, only on the later sale. On the later sale that occurs more than one year after the date of grant you recognize a taxable gain of $4.99 per share (not $5.00, because you get credit for the $0.01 per share you already took into income), and pay additional tax of $99,800 (i.e., $499,000 x 20%). Your economic gain after tax? $399,804 (i.e., $500,000 minus $396 minus $99,800).
Example 2 – No 83(b) Election:
In this example you do not file a Section 83(b) election. So you pay no tax at grant (because the shares are unvested), but instead recognize income of $100,000 when the shares vest and thus have ordinary income tax of $39,600. On the later sale that occurs more than one year after the date of vesting you recognize a taxable gain of $4.00 per share (not $5.00, because you get credit for the $1.00 per share you already took into income), and pay additional tax of $80,000 (i.e., $400,000 x 20%). Your economic gain after tax? $380,400 (i.e., $500,000 minus $39,600 minus $80,000).
So in the above example, filing a Section 83(b) election would have saved you $19,404. Filing a Section 83(b) election also has two other benefits. It would have prevented you from having a $39,600 tax hit when the stock vested, which may have been at a time you may not have had cash to pay the tax, and it also starts your long-term capital gains holding period clock earlier – meaning that you get the long-term capital gains rate as long as the sale of your shares occurs more than a year after grant, rather than a year after vesting.
Why doesn’t everyone file one? If you receive restricted stock even if it is worth a nominal amount, it virtually always makes sense to file one. However, what if instead of receiving 100,000 shares of restricted stock worth $0.01 per share, you received 100,000 shares of restricted stock worth $1.00 per share? Filing a tax code Section 83(b) election would immediately cause you tens of thousands of dollars of tax. And if the company subsequently fails, and in particular if it fails before your stock vests, you likely would have been economically better off to not have filed a Section 83(b) election.
So if you have faith in your company, file the 83(b) election.
The filing must be made (if at all) within 30 days after the grant date of your restricted stock, as that is an absolute deadline that cannot be cured. And note that the grant date of your restricted stock is usually the date the board approves the grant, even if you don’t receive the restricted stock paperwork until later – so sometimes you need to be super efficient about making this decision and filing the correct paperwork.
Here is a tip: send TWO COPIES of the Section 83(b) election form along with a self-addressed stamped envelope. Then the IRS will file-stamp one of them and send it back to you. They don’t send your original form back to you and if they lose it then there is no proof that you filed one on time. That’s why we always file two of them with a SASE.
HOW THE IRS JUST MADE IT EASIER TO FILE An 83(b) ELECTION
Until now, you were required to file an 83(b) election with your tax return the year in which the property was transferred. But guess what?!! TurboTax and some other electronic filing systems do not have this 83(b) feature built in to their system sometimes, so it was always very difficult to file these 83(b) forms. Thank you IRS for making this step of the Section 83(b) election process easier.