For founders and early employees of promising startups, equity compensation often comes with complex tax situations. One such situation is deciding whether to file an 83(b) election, a choice that could significantly impact your future tax liability. Understanding this often-overlooked tax provision can be pivotal in maximizing the value of your equity stake, potentially reducing your tax burden as your company grows.
Dealing with deadlines, paperwork, and confusing tax jargon can make understanding the 83(b) election feel like navigating a financial maze. This guide aims to demystify the 83(b) election. We’ll provide a clear, practical understanding for anyone who’s received restricted stock or stock options from a company. Let’s explore the key concepts of the 83(b) election so you can make informed financial decisions for your startup journey.
What is an 83(b) Election?
An 83(b) election is a tax election you can make when granted restricted stock, purchased restricted stock upon formation of a company, or exercised stock options in a company. Filing an 83(b) election means you choose to pay taxes on the entire value of your equity compensation upfront. This payment happens at the time of grant, instead of as it vests. This choice typically leads to lower taxes in the long run as the stock price appreciates over time.
How Does an 83(b) Election Work?
You usually pay taxes on restricted stock awards (RSAs) or restricted stock units (RSUs) when they vest. If you believe the company’s stock will increase in value, making an 83(b) election within 30 days of receiving the stock may be beneficial. JPMorgan suggests that future gains beyond that point will be taxed at the potentially lower capital gains rate. This rate applies when you sell the stock instead of your ordinary income tax rate as it vests, potentially saving you a substantial amount of money if your company experiences rapid growth.
Without an 83(b) election, you will be taxed at your ordinary income tax rate each time your equity vests. The taxable amount is the difference between the current value at that time and the initial grant price.
8 Tax Benefits of 83(b) Election
An 83(b) election can provide several tax benefits to individuals who receive restricted stock or other types of property as part of their compensation. Here’s a detailed list of these benefits:
1. Potential for Lower Initial Taxation
By making an 83(b) election, the recipient can choose to be taxed on the value of the restricted stock at the time it is granted, rather than at the time it vests. If the stock has a low fair market value (FMV) at the time of grant, the initial tax burden will be minimal, potentially resulting in significant tax savings.
2. Capital Gains Treatment
Without an 83(b) election, any appreciation in the value of the stock between the grant date and the vesting date is taxed as ordinary income upon vesting. With the election, the recipient pays tax on the value at the grant date, and any subsequent increase in value is taxed as a capital gain when the stock is sold. Capital gains rates are generally lower than ordinary income tax rates, leading to potential tax savings.
3. Start the Holding Period for Capital Gains
Making the 83(b) election starts the holding period for long-term capital gains purposes at the date of the grant. This means that the recipient could potentially qualify for the lower long-term capital gains tax rate (currently 0%, 15%, or 20% depending on the individual’s income) if they hold the stock for more than one year from the grant date, rather than from the vesting date.
4. Lock in the Value for Taxation
When the stock is granted at a low value and the company’s prospects are strong, making an 83(b) election locks in the value at the time of grant. This can be particularly advantageous if the stock’s value is expected to increase significantly by the time it vests.
5. Avoid Double Taxation on Subsequent Appreciation
Without the 83(b) election, any increase in stock value from the grant date to the vesting date is taxed as ordinary income, and then the increase from the vesting date to the sale date is taxed as a capital gain. With the election, only the appreciation after the grant date is subject to capital gains tax, avoiding double taxation.
6. Potential Tax Deferral
While making an 83(b) election requires paying taxes on the grant date value, it can result in a deferral of larger tax liabilities until the stock is sold, provided the stock’s value appreciates. This deferral can be beneficial for cash flow purposes.
7. Tax Planning Opportunities
The 83(b) election allows for better tax planning. Individuals can make informed decisions based on their financial situation, future income projections, and the expected performance of the company. This flexibility can lead to more efficient tax outcomes.
8. Estate Planning Benefits
If the stock is expected to appreciate significantly, making an 83(b) election can be advantageous for estate planning. The election allows the stock to be included in the individual’s estate at its lower grant date value, potentially reducing estate taxes if the stock is transferred or bequeathed.
How to Make an 83(b) Election
Here are some practical guidelines from the IRS for those eligible and interested in potentially reducing their tax burden using an 83(b) election:
- Within 30 Days: Make sure you file within 30 calendar days from the date you receive your shares.
- IRS Filing: Send your completed 83(b) election form and required documents via USPS Certified Mail to the correct IRS office, opting for a Return Receipt. Be sure to keep your tracking info safe.
- Additional Recommendations: Although not a requirement, consider including an extra copy of your completed form with a self-addressed stamped envelope along with your original signed election when you mail it to the IRS.
- Employer Copy: Give your employer a heads-up and share a copy of your filed 83(b) form. This can be done through email or other suitable methods.
- Safeguard Proof: Hold onto a copy of your signed 83(b) form and any return receipts – these can be crucial down the line.
Making an 83(b) election might be complex, but the benefits could save you in taxes in the future. Consider this proactive move if you believe your startup will increase in value and you are not concerned about potentially losing the shares. This is especially important if the business takes an unforeseen downturn.
FAQs About 83(b) Election
How Does an 83(b) Election Work?
An 83(b) election allows recipients of restricted securities, including stock options, to potentially lower their tax burden. This is achieved by paying taxes on the total fair market value (FMV) at the time of issuance. Carta refers to this as early exercising, which involves informing the IRS by filing an 83(b) election to secure this favorable tax treatment.
What Happens if You Don’t File an 83(b) Election?
Failing to make an 83(b) election within 30 days can have tax consequences. If your company’s value increases from when you received the shares and you didn’t file an 83(b), you’ll pay higher taxes when your shares vest or sell later, depending on your grant type.
What is the Risk of an 83(b) Election?
The main risk with filing an 83(b) election is the uncertainty of a startup’s future success. If you leave the company before the stock fully vests, or the company’s value declines, you may have paid taxes on a higher valuation than what you eventually receive. Additionally, getting the IRS’s consent to revoke an 83(b) election can be quite difficult.
Typically, revocation is only permitted within 60 days of the initial filing and requires compelling reasons. This could include proving the election was made due to a misunderstanding about the transaction.
What is the 83(b) Election for Founder Stock?
Section 83(b) of the Internal Revenue Code can help reduce tax burdens for founders who receive stock with a low initial value, such as $0.001 per share. The IRS recognizes this as its current fair market value. Filing an 83(b) election lets you pay tax upfront on that minimal amount.
Let’s say your startup thrives, and the stock price jumps to $10 a share upon vesting. Because you filed an 83(b) election, you may now be eligible for the lower, long-term capital gains tax rate on the $9.999 gain per share when you sell. This is because your holding period starts earlier at granting instead of vesting.
Conclusion
The decision of whether or not to file an 83(b) election is important and should not be taken lightly. It’s generally wise to consult with qualified financial and tax advisors. Their insights, tailored to your situation, can help determine the best course of action.
However, this overview of the 83(b) election provides practical examples to give you a solid starting point for understanding this critical financial tool. An 83(b) election can potentially minimize your future tax obligations. Remember, careful planning and informed choices pave the path towards a more financially secure and rewarding startup experience.
