83(b) Election: What Is It & Should You File It?

The 83(b) election is a powerful tax savings strategy but knowing when to file one is not always straightforward. If you are a founder or early employee of a startup and wish to maximize your “cash out” opportunity (net take home after taxes), then putting more of your hard-earned equity in your pocket shouldn’t be an afterthought.

The IRS tax code is very effective at taxing increases in your wealth. Asset appreciation in the form of company stock is no different, which is why it’s important to take full advantage of any potential tax savings strategies that are available to you, especially since your equity compensation may very well be the largest increase of wealth in your lifetime. Before you go running off to file, let’s dive into an 83(b) election and what it entails.

What is an 83(b) election? 

This refers to an election that gives a founder or an employee of a startup the option of notifying the IRS that they wish to be taxed on the date their equity is granted rather than when it vests.  

How do you know if you are eligible? 

Typically, there are two requirements that will satisfy your eligibility. First, the shares issued are restricted stock. Second, your shares are subject to vesting. If both boxes are checked, then the election should be approved by the company. (note: Restricted Stock Units (RSUs) are different from restricted stock that a founder or an early employee would receive at a start-up. RSUs are not eligible for this type of election.)

Do stock options apply? 

If you have 83 (b) election for stock options and your company offers 83b early exercise, then you may be eligible to file. However, this is quite rare and is generally not common practice since early exercise of an option may not be in your best interest.

How does it work?

Because you’re electing to pay income tax up front when the shares are granted at the Fair Market Value, then any further appreciation in the value of your shares may result in tax savings. 

Let’s assume a startup employee is issued 500,000 in restricted shares at XYZ company that vest over four years. If an 83(b) election is filed, then the fair market value of the 500,000 shares is recognized as compensation income at the time of grant and is taxed as ordinary income.    

Here’s the math:

 

Income tax of $17,500 is paid on the $50,000 at the onset, because the substantial risk of forfeiture was removed when the 83(b) was filed. Moving forward, the shares will vest according to the vesting dates with no additional tax due.

(Note: The example assumes a 35% marginal tax bracket (ordinary income))                                                                              

Now Instead, let’s assume you did not request this election. When the first 125,000 shares vest after one year, the employee would need to pay income tax on the full fair market value of those shares as of the vesting date (tax owed = $32,813). To carry on with the example, let’s assume the shares are valued at $0.10 on the grant date, $0.75 at the end of one year, $1.50 after two years, $3 after three years, and $6 after the fourth year.

The real impact of not electing an 83(b)

Start-up shares are associated with privately held stock, which lack liquidity. Although you don’t have to purchase your restricted shares when they vest, you still need to have sufficient funds to pay the income taxes. This could be a huge problem, because selling your illiquid stock to pay the tax may not be an option. A timely 83(b) election could help you avoid this nightmare scenario.

The difference in taxes paid out of pocket in the example above if you elected vs. not elected the 83(B) was quite significant: ($474,688).

To elect or not to elect, what’s the strategy?

Recall that the IRS is very effective at taxing increases in your wealth. If you are confident that your restricted stock will appreciate significantly between the grant date and vest date, then you may want to consider accelerating tax on the shares by filing the 83(b) and recognizing the tax at the onset. This will also assign any future appreciation in the stock price to the capital gains tax category. By electing an 83(b), you shift the tax from what would be considered compensation income to more favorable capital gains treatment, which generally means more money in your pocket. Capital gains have traditionally been lower than ordinary income tax. 

When does it not make sense to elect an 83(b)? 

Although it generally makes sense for startup employees and founders to file an 83(b), there are a few instances where it does not.    

• If you are not confident in the company’s outlook, and expect the shares to decrease, then you could hold off and recognize tax on the lower-valued shares as they vest. If you went ahead and made the 83(b) election, the tax paid would have been more than necessary.
• If you don’t plan on staying with the company long enough to hit the vesting periods or meet the financial milestones, then there wouldn’t be a reason to pay tax at the grant date, if you won’t be receiving the shares in the future.

There is a process, and the election must be made within 30 days from grant. 

A short, two-page letter needs to be sent via certified mail (tracking purposes) to the Internal Revenue Service within 30 days from the grant date. Also, mail a copy of the completed form to your employer. 

• Failure to file on time will void the election
• Be sure to consult with your tax professional
• An election is generally irrevocable if completed

Are you still unsure?

Your equity compensation is complex. It may be time to consult with a tax professional or financial planner. Making informed decisions about your stock options can be a struggle if you lack time, knowledge, or resources.

Who can I reach out to for my 83(b) election in Los Angeles?

If you don’t want to miss the 83(b) election deadline, Augustus Wealth is here to guide you through the process. In addition, our financial advisors are  well-versed in the meticulous process of 409A valuations, offering insights that shape your investment strategy. Additionally, our seasoned team in Los Angels County is adept at navigating the complexities of 10b5-1 trading plans, providing you with a comprehensive approach to safeguarding your stock holdings and knowing when to buy or sell. Trust us to be your partner in making well-informed decisions that contribute to the longevity and prosperity of your financial portfolio.