Your Startup Could Benefit from an 83b Election – Find Out How
posted Apr 10, 2017 by Paul Oliveira, CPA
A Section 83(b) election is a valuable tool for managers/investors who have been granted equity in their company as part of their employment package. When you’re given equity in a company as part of your compensation, you are required to pay taxes on it just as you would on any other cash compensation that you receive. How much of the equity grant is considered taxable? That will depend on the fair market value of the equity you receive and whether it is subject to a substantial risk of forfeiture, such as vesting.
For example, your company grants you stock that is subject to a 5 year vesting schedule. Assume further you are not required to pay anything for the stock awarded to you. The general rule requires that you be taxed each year on the fair market value of the shares that vested during the year. As the value of the stock rises (hopefully!) during this 5 year vesting period, you will be paying an increasing amount of tax each year as you vest in the stock. This income is taxed as compensation income, which is subject to the higher ordinary income tax rates. But a Section 83(b) election could be a good strategy in preserving more of that appreciation in value occurring during the vesting period as capital gain when you dispose of the stock, rather than compensation income.
Section 83(b) election
By making this election when the equity award is first granted, you are agreeing to be taxed for the entire amount of the award at the current fair market value of the shares, even though you are not yet fully vested. In making this election, you are betting that the value of the award will rise during the vesting period and that it is cheaper for you to pay the tax on compensation income up front at today’s value rather than pay it over time as the shares vest.
Let’s go back to our previous example. Assume you are awarded 5,000 shares, subject to 5 year vesting, which are worth $0.01 on the date of grant. On each vesting date over the next five years, the value of the shares increase by $0.10, so that by the fifth and final vesting date, the shares are worth $0.51.
By making a Section 83(b) election, you will be taxed on $50 (5,000 shares at $0.01per share) of compensation income taxed at ordinary income tax rates. All of the appreciation that occurs after the date of grant will ultimately be taxed at the lower capital gain tax rates when you ultimately dispose of the shares.
Without a Section 83(b) election, your taxable compensation income on each vesting date would be:
- Vesting after Year 1 $110 (1,000 shares @ $0.11/share)
- Year 2 210 (1,000 shares @$0.21/share)
- Year 3 310 (1,000 shares @ $0.31/share)
- Year 4 410 (1,000 shares @ $0.41/share)
- Year 5 510 (1,000 shares @ $0.51/share)
Again, making the Section 83(b) requires confidence in your company’s prospects and that the value of the shares you are being awarded will rise. This example points out that not at least considering making the election could cost you a fair amount of tax over time.
How to make the election
In order to make this election, you have to send a letter to the IRS within thirty (30) days of the grant date.
The undersigned taxpayer hereby elects, pursuant to § 83(b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess (if any) of the fair market value of the shares described below over the amount paid for those shares.
The name, taxpayer identification number, address of the undersigned, and the taxable year for which this election is being made are:
- TAXPAYER’S NAME:
- TAXPAYER’S SOCIAL SECURITY NUMBER:
- TAXABLE YEAR: Calendar Year 20
- The property which is the subject of this election is shares of common stock of [ ].
- The property was transferred to the undersigned on [DATE].
- The property is subject to the following restrictions: [Describe applicable restrictions here.]
- The fair market value of the property at the time of transfer (determined without regard to any restriction other than a non-lapse restriction as defined in § 1.83-3(h) of the Income Tax Regulations) is: $ per share (multiplied by the number of shares) = $.
- For the property transferred, the undersigned paid $ per share (multiplied by the number of shares) = $.
- The amount to include in gross income is $. [The result of the amount reported in Item 5 minus the amount reported in Item 6.]
The undersigned taxpayer will file this election with the Internal Revenue Service office with which a taxpayer files his or her annual income tax return not later than 30 days after the date of transfer of the property. A copy of the election also will be furnished to the person for whom the services were performed. Additionally, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which the property is transferred. The undersigned is the person performing the services in connection with which the property was transferred.
Many employers will provide this letter to the executive as part of the package of materials describing the award grant. However, it is the responsibility of the grant recipient to sign the letter and make sure the election is filed within the prescribed time.
Whether you are an executive with a startup that is receiving a restricted grant of stock, or perhaps an employer that is trying to devise an appropriate compensation plan, we can help. Please feel free to reach out to us.