As your company approaches IPO, you have a lot of important decisions to make. If you’ve received stock options or a restricted stock award, you may be able to take advantage of Internal Revenue Code Section 83(b). Under certain circumstances, this provision allows taxpayers to report the taxable gain on these benefits early, when it’s likely to be lower.
How does an 83(b) election work?
Some companies allow employees to exercise their stock options before they vest. If an employee exercises their options early, they have 30 days after the date of exercise to file an 83(b) election. Restricted stock awards (RSAs) are company shares and do not need to be exercised. RSA recipients have 30 days after the grant date to file the election.
When an employee exercises options or receives restricted stock, they pay a predetermined discounted price for their shares, commonly called the strike price. The difference between the strike price and the fair market value of the shares is the gain that the employee must report for calculating taxes. An 83(b) election essentially bumps up the date on which the fair market value is determined. In the case of stock options, this is the exercise date, and in the case of RSAs, it’s the date the 83(b) election is filed.
How can an 83(b) election reduce taxable income?
When a company is healthy and growing, as it must be to be on the path to IPO, its share price is generally expected to increase over time. Shares can see dramatic jumps in market value after an IPO. Because your gain for tax purposes will be the shares’ fair market value minus the price you paid for them, calculating the gain when the market value is low results in a lower figure to report for tax purposes.
The gain on stock options and RSAs is normally calculated when they are exercised. The gain on RSAs is taxed as ordinary income. The gain on stock options is treated differently depending on the type of options the employee owns: incentive stock options (ISOs) or nonqualified stock options (NSOs). NSOs are taxable as ordinary income; ISOs do not have to be reported as ordinary income but must be included in the alternative minimum tax (AMT) calculation.
Are there drawbacks to filing an 83(b) election?
While an 83(b) election can often result in substantial tax savings, it isn’t always the right choice. Here are a couple of ways an 83(b) election could go wrong.
One of the requirements of 83(b) is that the underlying stock must be subject to forfeiture. If you leave your company, for example, or if other vesting conditions aren’t met, then you could be left paying taxes on shares that you never actually receive. Alternatively, the share price could fall and be lower at the time of vesting that on the grant date. In this event, the shareholder would be stuck with the higher market value for tax purposes. Either way, the taxpayer won’t be eligible for a refund of any overpayment.
Unaffordable Tax Burden
The most significant drawback of using an 83(b) election is that it triggers taxation on unrealized income. Because you may not see any return on your investment in company shares for many months or even years, it can be a significant challenge to meet the tax burden that follows an 83(b) election. Before you decide to file, make sure to have a plan in place to cover the tax bill that will result. A tax professional who has experience working with clients through the IPO process can help you anticipate the tax impact of your election.
Making the 83(b) Decision
Whether to make an 83(b) election is just one of many major decisions you’ll be facing throughout your company’s IPO process. A knowledgeable guide who understands the opportunities and pitfalls of this journey will be a valuable ally in the coming months as well as over the long term. WRP specializes in providing personalized IPO planning and wealth management for startup executives and employees. For more pro tips, browse our resource center or our blog!