WRP's 2024 Crash Course in 83(b) Elections: Optimizing Your Equity Compensation Strategy

Navigating the complexities of startup equity and executive compensation can be daunting, especially when it comes to understanding critical yet often misunderstood topics like the 83(b) election. Whether you're a founder, early employee, or seasoned executive, grasping this tax strategy can dramatically influence your financial future. This guide aims to demystify 83(b) elections and provide you with the insights needed to make informed decisions about your equity compensation.

An 83(b) election is a provision under the Internal Revenue Code that allows individuals to elect to pay taxes on the full fair market value of restricted stock or early-exercised stock options at the time of grant or exercise, rather than upon vesting. This pivotal decision can lead to significant tax savings, especially if the stock's value is expected to rise sharply over time.

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.

• Timeliness: The election must be filed within 30 days of receiving the restricted stock or exercising the options.
• Voluntary Decision: It's a proactive choice that affects your tax liabilities.
• Scope: This applies specifically to equity compensation subject to certain vesting conditions.

• Eligible Parties: Employees awarded restricted stock, founders receiving stock subject to vesting, and employees who choose to exercise their stock options early.
• Verification Needed: Always confirm with your company's HR or legal department regarding eligibility for making an 83(b) election, as not all compensation plans permit it.

• Tax Savings Potential: By opting to pay taxes on the current fair market value, you might save significantly as the value of the stock increases.
• Capital Gains Considerations: The capital gains holding period begins at the time of the election, which could lead to more favorable tax treatment upon eventual sale. Additionally, for eligible companies, this election can start the clock for QSBS (Qualified Small Business Stock) treatment, potentially allowing for significant tax benefits if held for at least 5 years.
• Simplification of Tax Filings: Post-election, you won't need to report income as shares vest, simplifying your future tax reporting requirements.

• Immediate Tax Liability: You are required to pay taxes upfront on a notional income that might never materialize if the stock value declines.
• Risk of Overpayment: If the stock's value decreases, you may find that you have paid more in taxes than the stock is ultimately worth.
• Forfeiture Risk: If you leave the company before the stock fully vests, you may forfeit your shares without a refund on the taxes paid.

Drafting the Election Statement

This document should include your personal details, specifics of the stock, and the value declared as income.

Ensure that this is done within the 30-day window following the grant or option exercise.

Provide them with a copy of the filed election.

Maintain copies of the election statement and any proof of mailing.

RSAs are often the most straightforward case for making an 83(b) election because:

• Recipients become stockholders immediately upon grant.
• The fair market value at grant is usually clear.
• Paying taxes early can be beneficial if significant appreciation is expected.
• It simplifies future tax reporting.
• Post-election appreciation is treated as capital gains.

Applicable mainly when early exercise is permitted.

Typically not eligible for 83(b) elections.

May involve special considerations in LLC or partnership contexts.

Ordinary Income Tax and Payroll Tax

For Non-Qualified Stock Options (NSOs):

• Ordinary income tax is applied on the difference between the fair market value at the time of the election and the purchase price.
• Payroll taxes (Social Security and Medicare) are also applicable to this amount.

For Incentive Stock Options (ISOs):

• No ordinary income tax or payroll taxes are applied at the time of exercise when making an 83(b) election.

This concerns any appreciation post-election when the stock is sold.

For those with incentive stock options (ISOs), 83(b) elections might affect how the Alternative Minimum Tax (AMT) is calculated:

• AMT Income: The spread at the time of exercise could be considered AMT income, possibly leading to AMT liability.
• AMT Credit: The AMT Credit is generated automatically. Proper planning for its use is the real key.
  
  Note: If you use a tax preparer who doesn't understand the difference between deferral and permanent preferences, they could potentially mess up your return.

Some states may have additional rules affecting the 83(b) election.

• Missing the Filing Window: Failure to file within the 30-day period results in a lost opportunity.
• Inadequate Planning: Not fully considering the financial and job stability impacts.
• State Filing Overlook: Ignoring additional state-specific filing requirements.

High applicability due to significant growth potential.

Considerations around long development cycles that might influence decision-making.

Less common but still potentially advantageous.

Anticipated modifications to tax laws could affect the viability and benefits of making an 83(b) election.

Evolving practices might introduce new factors to consider.

Making an 83(b) election is a strategic decision that can offer significant tax advantages under the right circumstances but also comes with risks that must be carefully weighed. Given the complexities involved, it's crucial to seek advice from tax professionals and financial advisors to ensure that your decision aligns with your overall financial strategy and goals.

At WRP Wealth Management, our experienced advisors are experts in equity compensation and can provide personalized guidance on whether an 83(b) election makes sense for your specific situation. We offer a holistic approach to financial planning, ensuring that your decisions are well-informed and tailored to your unique financial needs.

At WRP Wealth Management, we understand the complexities of equity compensation and the critical role that 83(b) elections can play in your financial future. Our team of experienced advisors specializes in helping tech executives, startup employees, and high-net-worth individuals make informed decisions about their equity compensation. Here's how we can assist you with 83(b) elections:

• Comprehensive Analysis: Our advisors will conduct a thorough analysis of your equity compensation package, considering factors such as your company's growth potential, your personal financial situation, and your long-term goals. We'll help you understand the potential impacts of making an 83(b) election versus not making one.
• Tax Optimization Strategies: Working in conjunction with WRP Tax, we provide integrated financial and tax advice. This holistic approach ensures that your 83(b) election decision aligns with your overall tax strategy, potentially saving you significant amounts in the long run.
• Cash Flow Planning: If you decide to make an 83(b) election, we'll help you plan for the upfront tax payment, ensuring it doesn't strain your short-term finances. We can explore strategies such as liquidating other assets or securing loans to fund the election if necessary.
• Risk Assessment: Our team will help you evaluate the risks associated with making an 83(b) election, including the potential for job loss or company failure. We'll work with you to develop contingency plans to mitigate these risks.
• Long-term Financial Planning: We'll incorporate your equity compensation and 83(b) election decision into your broader financial plan, ensuring it aligns with your retirement goals, estate planning, and other long-term objectives.
• Ongoing Monitoring and Adjustments: The decision to make an 83(b) election is just the beginning. We'll continue to monitor your equity position and make recommendations for adjustments as your company grows and your personal circumstances change.
• Education and Guidance: Our team stays up-to-date with the latest developments in tax law and equity compensation trends. We'll keep you informed about any changes that could impact your 83(b) election decision or its outcomes.
• Coordination with Legal and Tax Professionals: If needed, we can work with your company's legal team and your personal tax advisors to ensure all aspects of your 83(b) election are handled correctly and in compliance with current regulations.

At WRP, we believe that informed decisions lead to better outcomes. Our goal is to empower you with the knowledge and analysis you need to make the best choice regarding your 83(b) election. We understand that every situation is unique, and we're committed to providing personalized advice tailored to your specific circumstances.