What You Should Know About 83(b) Elections

When you file a timely 83(b) election, you are choosing to be taxed on the current value of your company shares, even though you haven’t yet experienced a taxable event and your shares are still subject to forfeit. This works a bit differently depending on what type of equity compensation you’ve received.

There are a few types of equity compensation for which filing an 83(b) election could be beneficial: incentive stock options (ISOs), non-qualified stock options (NSOs), and restricted stock awards (RSAs).

Many startups offer ISOs to entice and motivate employees. Incentive stock options, available only to company employees, represent the right, but not the obligation, to purchase a certain number of company shares at a specified discounted price (the “strike price”) during a limited period of time.

When shares vest, the bargain element (the difference between the strike price and fair market value) is included in the taxpayer’s alternative minimum tax (AMT) calculation. After ISOs are exercised and the corresponding shares are sold, any profit can become eligible for long-term capital gains treatment if shares are held for at least two years after grant and at least one year after exercise. Note that in order for the shares to be considered “held,” they must not be transferred in any way, including to a child, charity, or irrevocable trust.

Non-qualified stock options are another popular way for companies to attract, retain, and incentivize employees. Like ISOs, they give holders the opportunity to purchase discounted shares for a period of time. Unlike ISOs, they can be made available not only to employees but also to contractors, early investors, and anyone else the company decides to offer them.

NSOs do not get the same favorable tax treatment as ISOs. When you exercise non-qualified stock options, the bargain element is subject to ordinary income taxes. When you sell the corresponding shares, capital gains rates apply.

Some companies that issue incentive and/or non-qualified stock options allow employees to exercise these options before they vest. If an employee does so and files an 83(b) election within 30 days of early exercise, then those unvested shares become subject to tax at the time of exercise. At that time, the bargain element, calculated as the difference between the strike price and the fair market value at the time of exercise, is counted as income for the purpose of calculating the AMT.

The reason this can be beneficial is that in a company that is doing well, share prices are generally expected to increase over time. This increase can be substantial, and so can the tax liability that accompanies it. As a result, choosing to report income and be taxed on it early has the potential to significantly reduce a shareholder’s total tax obligation.

Rather than options to purchase shares, restricted stock awards are grants of company stock. Recipients may still have to pay a specified (but typically deeply discounted) price to receive the shares, but upon paying this price, they become immediate shareholders in the company, complete with voting rights. Although recipients own shares right away, they are not allowed to sell them until after they vest, which typically occurs over a period of years.

RSAs are taxed as ordinary income at the time that they vest based on their current market value, less any price that the employee may have paid for the shares. When the employee sells their shares, any difference between the fair market value at the time of vesting and the sale price is treated as a capital gain or loss.

An RSA recipient has 30 days from the grant of restricted stock to file an 83(b) election. If they do so, then the shares become taxable as ordinary income at their current market value on the date of election (minus any price paid). This provides a potential benefit similar to that of filing an 83(b) election for early-exercised options: the ability to be taxed early, when the value of shares is likely to be much lower than after they vest.

When you sell shares of stock, the tax treatment of your gains depends in part on how long you held them. In addition to allowing employee stockholders to pay taxes on shares when their value may be much lower, an 83(b) election also starts the clock on important these holding periods.

For early-exercised incentive stock options and restricted stock awards, an 83(b) election starts the clock on the one-year post-exercise holding period required to receive long-term rather than short-term capital gains treatment on the profits from share sales. Simply meeting this holding period requirement can sometimes result in tremendous tax savings. It is important to be aware, however, that if you plan to hold this stock for at least one year, then you must report the bargain element for AMT calculation in the year of exercise.

If your company stock meets the requirements of qualified small business stock, then holding your shares for at least five years before selling them could exempt your gains from federal taxes. Filing an 83(b) election begins this holding period as well.

Although an 83(b) election can result in considerable tax savings, it also carries significant risk. There is never any guarantee that shares in your company will increase in value—or, for that matter, have any value at all—before they’re fully vested and able to be sold. Tax consequences aside, it’s important to avoid risking more than you can afford to lose on your company shares.

If, in fact, the stock loses value, filing an 83(b) election could also cause you to pay more tax than you otherwise would have been obligated to. Since it is not possible to get this overpayment back in the form of a future deduction, it’s important to consider this very real risk before moving forward.

Whether you’re filing an 83(b) for stock options or restricted stock awards, you must submit a letter to the IRS within 30 days from the grant date. Additionally, you must send a letter to your employer letting them know that you’ve made an 83(b) election. Some jurisdictions also require submission of paperwork to state and/or local tax authorities, so check with your local tax advisor to make sure you’re meeting all relevant requirements.

If your company is in the IPO process, it’s important to seek advice from tax and financial professionals with IPO experience as soon as possible. Many different variables play into whether an 83(b) election is advisable, and you have only a short period of time to make this decision. In some cases, failing to make a timely 83(b) election can be very costly.

Because both tax and investment expertise are needed to make a fully considered decision about 83(b) election, it’s important to work with professionals who can provide trustworthy advice in both fields. The fiduciary advisors at WRP and our partners at WRP Tax work together to provide the very best in tax and investment advice with a focus on helping employees navigate their companies’ public offerings.