ISOs – The Importance of 83(b) Pt. 2

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The importance of 83b – Part II – RSA Examples

In Part I of “The Importance of 83b”, we did a survey of the 83b 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 83b election, and some of the potential negative consequences of the election.

Remember, by making an 83b 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 a 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 83b election (we will explore the mechanics of an 83b election in Part III). 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, her 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.

What if she didn’t make the 83b 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)
20,000 $1.10 $0.10 $20,000 $9,000
20,000 $2.10 $0.10 $40,000 $18,000
20,000 $4.10 $0.10 $80,000 $36,000
20,000 $8.10 $0.10 $160,000 $72,000
20,000 $16.10 $0.10 $320,000 $144,000

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 she 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 83b election effectively, she lowered her tax bill by $80,100 or 4% of the acquisition transaction.

But what if High Tech turned out to be a bust? There is downside risk to the 83b election. As mentioned in the first part of the above example, Janie had to pay $6,750 of tax up front. If High Tech shudders its doors in year two, Janie does not get her tax back. While $6,750 is a small price to pay, if she were awarded 1,000,000 shares or 10,000,000 shares, she’d be talking about more serious money.

This makes the 83b 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 83b 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 83b.