In Part I of “The Importance of 83(b),” we shared a survey of the 83(b) election, and discussed in what context the election made sense when it came to restricted stock awards (RSAs). In this post, we are going to go through some examples of what can be accomplished through making the 83(b) election and some of its potential negative consequences.
Making an 83(b) Election
Remember, by making an 83(b) election we are choosing to be taxed on something that is not currently taxable but may be in the future. The starkest example is when a person is granted RSAs and has a minimal purchase price. Assume Janie Taxpayer is CEO of High Tech Inc., a start-up company. High Tech offers Janie an RSA package that allows her to purchase 100,000 shares of High Tech for $0.10 per share. The shares vest over five years, annually. When awarded the RSAs, the value of the company is $0.25 a share.
Janie decides to file a timely 83(b) election. She chooses to be taxed on the full value of the stock, so to calculate her gain she takes the difference between the fair market value and the price she is going to pay, and then multiplies it by the number of shares that will vest. The math looks like this:
100,000 x ($0.25-$0.10) = $15,000
This means that in her current year income, she will recognize $15,000 of ordinary income and pay tax at her marginal rate. So, if she was in the 35% bracket for Federal and 10% for state, she would owe an additional $6,750 of tax.
If High Tech were acquired five years later at $20 per share, Janie’s cost basis would be $0.25 per share (the original taxable value of the stock), giving her a long-term capital gain of $1,975,000 (($20-$0.25)*100,000). If her long-term capital gain rate was 23.8% for Federal and 10% for State, she would owe $667,550, making her total tax paid $674,300.
Not Making an 83(b) Election
What if she didn’t make the 83(b) election? The good news is she won’t include the $15,000 of phantom income—but that’s the end of the good news.
Let’s assume that when the first vesting happens, the stock is valued at $1.10, the second vesting $2.10, the third vesting $4.10, the fourth vesting $8.10, and the fifth vesting $16.10. This is what the vesting schedule looks like:
|Shares Vested||FMV/Share||Cost/Share||Taxable Amount||Tax (45% Fed+State)|
The total tax paid before High Tech was acquired would have been $279,000. When High Tech gets acquired in year five, the first four vesting tranches will get long term capital gain treatment.
Since Janie was taxed as she went along, her basis will be $300,000 ($20,000+$40,000+$80,000+$160,000). Her long-term capital gain will be $1,300,000 ($1,600,000-$300,000), and the commiserate tax will be $439,400 (33.8% Fed+State). The last vest will get short term capital gain treatment (which is taxed like ordinary income plus 3.8%), so the gain of $80,000 ($400,000-$320,000) will have tax due of $36,000 ($80,000*48.5%).
The grand total she will have paid in tax would be $757,200 ($279,000+439,400+38,800).
By using the 83(b) election effectively, she lowered her tax bill by $80,100, or 4% of the acquisition transaction.
83(b) Election Risks
What if High Tech turned out to be a bust? There is downside risk to the 83(b) election. As mentioned in the first part of the above example, Janie had to pay $6,750 of tax up front. If High Tech shutters its doors in year two, Janie does not get her tax back. While $6,750 is a small price to pay, if she was awarded 1,000,000 shares or 10,000,000 shares, she’d be talking about more serious money.
This makes the 83(b) election a bit difficult. On the one hand, an executive would want to see something to make them bullish on the stock; on the other hand, by waiting, they could create more tax for themselves.
In Part III of 83(b) elections we’ll take a look at more traditional stock options. We’ll focus on incentive stock options (ISOs) and we’ll also dip into the tax compliance mechanics of 83(b). Subscribe to our blog to make sure you see the latest updates!