In part one of this two-part series, we reviewed how an 83(b) election works, how it can reduce taxable income, and the potential drawbacks of filing the election. In part two, we’ll look more closely at how 83(b) applies (or doesn’t apply) to different types of equity compensation as well as when the filing is more or less likely to be helpful. For a more comprehensive treatment of the 83(b) election, see our free ebook, What You Should Know About 83(b) Elections.
How does an 83(b) election apply to different types of equity compensation?
An 83(b) election applies only to specific types of equity compensation. Because its function is to declare income early for taxation purposes, the applicable shares must not yet be vested. Once shares vest, they are already subject to taxation.
For an 83(b) election to be used for stock options, those options must be eligible for early exercise; the election cannot be filed for unexercised options. After you early exercise stock options, you then have 30 days in which to file an (83)b election. The difference between the price you pay (the strike price) and the current fair market value (FMV), commonly known as the bargain element, is then taxable at the time of exercise. For this reason, 83(b) elections should be filed immediately after joining a company before the FMV of the stock has gone up.
The practical effect of 83(b) is a bit different depending on whether your options are incentive stock options (ISOs) or nonqualified stock options (NSOs). ISOs are a tax-favored form of stock option, and their bargain element is included in the alternative minimum tax (AMT) calculation. With NSOs, the bargain element is subject to ordinary income tax. In either case, however, filing the 83(b) election sets the reportable bargain element at the time of exercise. If the share price increases by the time of vesting, then filing the 83(b) election would reduce your total reportable income.
Awards of restricted stock are eligible for 83(b) election. When you receive a restricted stock award (RSA), the shares are yours immediately, complete with dividends and voting rights, even if they aren’t yet vested. This is in contrast to restricted stock units (RSUs), which are transferred to the employee at vesting. Because the IRS does not consider RSUs to be property of the employee until they are vested, RSUs are not eligible for 83(b) treatment.
RSAs typically vest according to a schedule. Without an 83(b) election, the value of shares, minus any price paid, is taxable as ordinary income at the time they vest. Filing an 83(b) within 30 days of your RSA grant date sets the value of all awarded shares at the time of filing and makes that income immediately taxable. If the share value increases throughout the course of the vesting schedule, then an 83(b) election would result in less reportable income.
When is filing an 83(b) likely to be beneficial?
One can never know for certain whether an 83(b) election will ultimately result in savings. Some factors, however, can make it more likely. If you own stock options in a promising company that’s on track for IPO, an 83(b) election could result in considerable savings in the event your company stock does well at IPO. Likewise, startup founders and key employees who receive large amounts of restricted stock stand to realize substantial savings through 83(b) election, since the value of their shares may increase greatly between the grant and vesting dates.
When you sell your shares, the difference between the price you paid and reported at the time of your 83(b) filing and the sale price (if higher) will be reportable as a capital gain. Additionally, filing the 83(b) starts the clock on the holding period for long-term capital gains. So, filing an 83(b) election not only has the potential to reduce taxes when you receive shares; it can also accelerate your ability to pay the lower long-term capital gains rate on your share sales.
When is an 83(b) election riskier?
It’s important to remember that 83(b) is designed to be a gamble. If you’re receiving options or a stock award from a more mature company rather than a startup, then its shares may have already reached a stable value. This makes filing an 83(b) election a riskier gamble than usual. If the share price declines after filing, then the tax you pay when you file the election will be higher than what you would have owed without the election. The IRS will not refund this difference to you (although you may recoup some of it by claiming capital loss).
However, if an 83(b) election is done right, you should pay no taxes. For this reason, other potential risks include:
- The price declines and you've paid more for exercising your options than the stock is now worth, resulting in a loss at sale.
- You leave the company (voluntarily or not), and your options have not vested. In this case, you forfeit the unvested shares you have early exercised and paid for.
- The company never has a liquidity event and the price you paid for the RSA/option is lost. In the event that the company completely goes out of business, you may be able to claim a loss. If the company stays private forever, you do not get that benefit.
Whether to file an 83(b) election for your stock options or restricted stock can be a complex decision. No matter what type of equity compensation you receive, the best way to get the most out of it is to work with an experienced fiduciary wealth manager. A trusted advisor with expertise in financial planning, investment, and tax strategy can work with you to design a plan to reach your financial goals and build the future you envision. To learn more, subscribe to our blog or browse our free resource library.