In Part I of “The Importance of 83(b),” we conducted 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 Part II, we looked at examples of 83(b) elections for RSAs. Now, in Part III, we’ll explore how incentive stock options (ISOs) can be impacted by 83(b) elections and talk about some of the 83(b) mechanics.
For a comprehensive overview of the 83(b) election, see our free guide, What You Should Know About 83(b) Elections.
Taxation of ISOs
To quickly review taxation of ISOs, we calculate the paper gain—also called the bargain element—on the ISO by taking fair market value of the ISO minus the strike price (what you’ll pay for the ISO). For regular income tax purposes, there is no tax on the bargain element.
So, if there is no regular income tax on the paper gain, why should we care whether we recognize the gain now or later? The answer lies in the alternative minimum tax (AMT). The AMT requires taxpayers to recognize the paper gain in the current year, and then levies as much as a 28% tax on the phantom income. This means the earlier you can recognize the gain, the lower it will be, which means a lower AMT.
There is, however, a catch. Taxpayers cannot make an 83(b) election on a stock option. In order to do an 83(b) election on the ISO, they need to early exercise. When employees early exercise the option, they pay for it before it technically vests. Should the employee separate before complete vesting, the company will return the lower of the purchase price or fair market value. Not all companies allow for early exercise of options, so check with HR before starting an analysis.
The AMT is a complex tax, so we recommend getting up to speed on the topic. Check out: What Pre-IPO Employees Should Know About the Alternative Minimum Tax (AMT).
Using 83(b) with ISOs
Let’s look at an example of how we can use an 83(b) election in an ISO situation:
Janie early exercises her ISOs and decides to file a timely 83(b) election. She effectively chooses to have the paper gain subject to AMT, so to calculate her gain, she takes the difference between the fair market value ($0.25) and the price she is going to pay ($0.10) 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 AMT difference and pay tax at her AMT rate. So, if she was in the 28% bracket, she would owe an additional $4,200 of tax. Of course, this depends on her other income. She may not have an AMT bill at all, making tax projections with a competent professional a must! She would also have to come up with $10,000 to purchase the stock.
The problem with waiting is that the AMT bill rises as the 409A valuation goes up. What if Janie waited to buy the stock when she felt more certain of an IPO? Let’s say the company starts to position for an IPO a year beforehand. The valuation of the stock is now $20/share. If she wants to get long-term capital treatment, she has to hold the stock one year from exercise. However, the calculation for AMT now looks like this:
100,000 x ($20.00-$0.10) = $1,990,000
This means that in her current year income she will recognize $1,990,000 of AMT difference and pay tax at her AMT rate. So, if she were in the 28% bracket, she would owe an additional $557,200 of tax. She would have an AMT credit on her return for future years, but that’ll take time to use, and she would still have to come up with over half a million dollars without selling a share of stock.
How to use 83(b)
Whether using 83(b) for ISOs or RSAs, getting the mechanics correct is crucial. Taxpayers are required to submit a letter to the IRS within 30 days from grant date. After filing that letter, employees must also send a letter to the employer letting them know an 83(b) election was made. Ask an attorney or CPA for a sample IRS letter. You’ll also want to check whether you are required to submit paperwork to your state or local tax jurisdiction.
The power of 83(b) can make a big difference in tax liability and cashflow for early employees at pre-IPO companies, but there are tradeoffs. For unsuccessful start-ups (and most are), employees can overpay taxes and lose money. This entices taxpayers to take a wait-and-see approach. However, waiting too long can make the 83(b) election too expensive to exercise, especially on rapidly increasing 409A valuations. As always, consult with competent legal, accounting, and financial counsel.
While Part III is the last part in our Importance of 83(b) series, it's still critical to develop an early understanding of the 83(b) election. View our blog, 3 Essential Questions About 83(b) Elections, where we share our answers to the most common questions we get about 83(b) elections. For more information about your election options and other financial management advice, subscribe to our blog.