What is an 83(b) election?
When you file an 83(b) election, you’re taking advantage of section 83(b) of the Internal Revenue Code (IRC). This provision allows early investors in a company, including employees receiving equity compensation, to calculate and pay tax on their shares before they vest. You have 30 days from the date you are granted certain types of equity compensation to file an 83(b) election. Because of this short timeframe, it’s essential to learn about the pros and cons of an 83(b) filing—and how it could affect your financial future—early in your company’s IPO process.
What’s the purpose of filing an 83(b) election?
When a company does well, its share price rises. When you receive equity compensation in a startup company, its initial value is generally low compared to its expected future value. Consequently, choosing to be taxed on this compensation sooner rather than later can result in sizable tax savings.
When can an 83(b) election be useful?
Early Exercise of Stock Options
Many companies that provide stock options allow employees to exercise them early, before they vest. If early exercise is available to you, then an 83(b) election could limit your tax burden. First, you’ll need to early exercise your options, purchasing the company stock before it vests. You’ll then have 30 days from the date of early exercise to file an 83(b) election. If you do, then the bargain element (the difference between the price you pay for your shares and their current fair market value) is subject to tax at the time of exercise. In a pre-IPO company, this bargain element is likely to be small and may even be zero.
ISOs vs. NSOs
Companies may grant employees incentive stock options (ISOs), nonqualified stock options (NSOs), or a combination of these. The main difference between these types of stock options is how they are taxed. Without an 83(b) election, the bargain element of ISOs is included in the alternative minimum tax (AMT) calculation at the time of vesting. The bargain element of NSOs, on the other hand, is subject to ordinary income tax. It’s important to consult with a tax advisor who is knowledgeable about stock options and the IPO process to gain a full understanding of and develop a plan for the tax implications of your equity compensation.
While stock options represent the right to purchase shares at a specified price, restricted stock awards are grants of company shares. If you receive RSAs, you may still have a minimal strike price to pay. Upon paying any required strike price, you become a full shareholder with voting rights; however, you will not be allowed to sell your shares until after they vest.
Ordinarily, the bargain element of RSAs is taxable as ordinary income at the time they vest. If you file an 83(b) election within 30 days after receiving a restricted stock award, then this bargain element becomes taxable on the date you file the election.
Are there drawbacks to making an 83(b) election?
Filing an 83(b) election has the potential to save a considerable amount in taxes, but it also comes with substantial risks. While you may hope and expect your company shares to rise in value, it’s not a certainty. As with any investment, it’s important to carefully evaluate the risk of investing in your company and avoid betting more than you can afford to lose. An experienced and trusted investment advisor can help you assess the risks and benefits of exercising stock options or purchasing RSA shares.
In addition to the risk of loss inherent in the investment itself, there is also a risk that an 83(b) election could result in having to pay more tax than you would otherwise owe. This can happen if you file an 83(b) election and your shares subsequently lose value. In this case, there is no credit available to recover the tax overpayment.
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WRP, in conjunction with our partner, WRP Tax, specializes in providing trusted investment advice and tax guidance to employees and executives in pre-IPO companies. For more valuable insight into tax and investment topics, browse the WRP blog!