83(b) Election

DEFINITION of '83(b) Election'

The 83(b) election is a provision under the Internal Revenue Code (IRC) that gives an employee or startup founder the option to pay taxes on the total fair market value of restricted stock at the time the stock is granted to him or her. The 83(b) election applies to equity that is subject to vesting, and notifies the Internal Revenue Service (IRS) to tax the elector for the equity at the time it was granted, rather than at the time the stock was vested.

In effect, an 83(b) election means that you pre-pay your tax liability on a low valuation, assuming the equity value increases in the following years. However, if the value of the company instead declines consistently and continuously, this tax strategy would ultimately mean that you overpaid in taxes by pre-paying on a higher equity valuation.

BREAKING DOWN '83(b) Election'

Normally, when a founder or employee is compensated with equity of a company, the equity is subject to income tax according to its value. The fair market value of the equity at the time the equity is granted or transferred to the recipient is used to assess how much tax the recipient will be liable for. The tax due has to be paid in the actual year that the stock is granted or transferred to the employee or founder. However, in many cases, the equity is vested over a number of years so that the employees can actually earn the stocks granted them, in which case, tax is paid on the equity value at the time of vesting. The problem with the vesting scenario is that if the company’s value grows over the vesting period, the tax paid during each vested year will also rise significantly.

For example, a co-founder of a company is granted 1 million shares subject to vesting and valued at $0.001 at the time the shares are granted him. At this time, the shares are worth the par value of $0.001 x number of shares = $1,000, which the co-founder pays. The shares represent a 10% ownership of the firm for the co-founder and will be vested over a period of five years, which means that he will receive 200,000 shares every year for five years. In each of the five vested years, he will have to pay tax on the fair market value of the 200,000 shares vested. If the total value of the company’s equity increases to $100,000, then the co-founder’s 10% value increases to $10,000 from $1,000. His tax liability for year 1 will be deduced from ($10,000 - $1,000) x 20% i.e. in effect, ($100,000 - $10,000) x 10% x 20% = $1,800.

Where $100,000 is the Year 1 value of the firm;

$10,000 is the value of the firm at inception i.e. book value;

10% is the ownership stake of the co-founder;

20% represents the 5-yr vesting period for the co-founder’s 1 million shares i.e. (200,000 shares/1 million shares) x 100.

If in year 2, the stock value increases further to $500,000, he will pay taxes on ($500,000 - $10,000) x 10% x 20% = $9,800. By year 3, the value goes up to $1 million and his tax liability will be assessed from ($1 million - $10,000) x 10% x 20% = $19,800. Of course, if the total value of equity keeps climbing in Year 4 and Year 5, the co-founder’s additional taxable income will also increase for each of the years.

If all the shares are sold for a profit at a later year, the co-founder will be subject to a capital gains tax on his gain from the proceeds of the sale.

The 83(b) election gives the co-founder the option to pay taxes on the equity upfront before the vesting period starts. If he elects this tax strategy, he will only need to pay tax on the book value of $1,000. The 83(b) election notifies the IRS that the elector has opted to report the difference between the amount paid for the stock and the fair market value of the stock as taxable income. The value of his shares during the 5-yr vesting period will not matter as he won’t pay additional tax and he gets to retain his vested shares. However, if he sells the shares for a gain, a capital gains tax will be applied. Following our example above, if he makes an 83(b) election to pay tax on the value of the stock when it was granted to him, his tax assessment will be made on $1,000 only. If he sells his stock after, say, ten years for $250,000, his capital gain will be $250,000 - $1,000 = $249,000 and this amount will be subject to a capital gains tax.

The 83(b) election makes the most sense when the elector is sure that the value of the equity is going to increase over the coming years. Also, if the amount of income reported is small when a stock was granted, an 83(b) election might be beneficial.

In a reverse scenario where the 83(b) election was triggered and the equity value actually falls or the company files for bankruptcy, then it will turn out that the employee or founder actually overpaid in taxes for shares with a lesser value or shares that became worthless. Unfortunately, the IRS does not allow a claim to be made on the overpayment of taxes under the 83(b) election. For example, consider an employee whose total tax liability upfront after filing for an 83(b) election is $50,000. Since the vested stock proceeds to decline over a 4-year vested period, s/he would have been better off without the 83(b) election and paying annual tax on the reduced value of the vested equity for each of the four years, assuming the decline is significant.

Another instance where an 83(b) election would turn out to be a disadvantage would be if the employee leaves the firm before the vested period is over. In this case, s/he would have paid taxes on shares that would never be retained or received. Also, if the amount of reported income is substantial at the time a stock is granted, filing for an 83(b) election will not make much sense.

The form for an 83(b) election must be completed and mailed to the IRS within 30 days the restricted shares are granted to an employee or founder. In addition to notifying the IRS of the election, the recipient of the equity must also submit a copy of the completed election form to her employer and also include a copy in her annual tax return.