All members of rapidly expanding businesses need to read this. Compensation packages for early stage startups come with perks including stock. When you receive equity in exchange for work, you must act quickly and file an 83(b) election, to shelter you from high taxes on your vested shares.
In this article:
- What is an 83(b) election?
- Stock with a substantial risk of forfeiture
- Example of tax savings with 83(b) election
- How to write an 83(b) election form
What Is An 83(b) Election?
A Section 83(b) election permits restricted stock to be taxed upon receipt versus after it matures. This allows the employee of the company to file certain stock as income when it is granted or exercised. 83b minimizes taxes by 50-60% for restricted stock awards (RSAs), incentive stock options (ISOs) and profits interest units (PIUs) because you are taxed on the fair market value of your shares before they mature.
Get familiar with these 83(b) election terms:
Vesting Period: a contractual holding and maturity period before an employee has the right to cash in on stock units.
Strike Price: set price for stock options to be purchased or sold.
Fair Market Value: the fair market value price of shares as if they were being sold in the open market.
Granted Stock: the date of which stock has been given to an employee.
Exercised Stock Options: the date at which stock has been purchased or sold according to company terms.
For startups, this tax law is advantageous at the company level too. Startup founders and early employees are often compensated with stock units conditional upon a working contract. If a working relationship ends before the vesting period completion, a company may repurchase the stock units at the strike price under an 83b. So they encourage making this election because it helps the employee and the company save money.
Substantial Risk Of Forfeiture
Section 83(b) election only applies to shares that are at substantial risk of forfeiture. This means the stock is subject to a holding period before an employee has full rights. The holding period requires you to stay with a company for a certain amount of time, or reach a milestone. You forfeit your stock, and any potential payments you made if you leave the startup.
Shares with a substantial risk of forfeiture, are coupled with conditions for an employer buyback. Your employer may repurchase your shares at the strike price, or a discounted price set in the contract. This price doesn’t always match the fair market value therefore you would lose out on that money.
The only asset that cannot be claimed as an 83b is non-statutory aka non-qualified stock option (NSOs). This is stock that is not at risk of forfeiture. This election is open to company stock that can be exercised early before the vesting period. These are the types of stock allowable under Section 83(b):
Restricted stock units (RSU)
A type of employee compensation where shares are granted. RSUs can be an equity exchange for work, reserved for first employees at startups, different from a right to purchase. The vesting period for RSUs is typically 3-5 years or set to measurable company goals, like earnings and revenue. No dividends are given with RSUs and they have no value to the employee until they are vested.
Incentive Stock Options (ISOs)
Incentive stock options (ISOs) are the right to buy shares at a strike price that is less than fair market value (FMV). They are part of compensation plans at incorporated businesses to encourage loyalty and increase share prices.
Employees do NOT have to purchase ISOs, it is simply an option. When an employee purchases stock options they are exercising their rights to the stock. Companies usually include terms like vesting periods after exercise or strike prices for resale.
Profits Interest Units (PIUs)
Profits interest units (PIUs) are a promise of a percentage of future profits. This is equity in exchange for work at LLCs. This type of equity is given to employees and is also subject to a vesting period. The fair market value of PIUs, when granted at inception, has a zero dollar value ($0).
Rules For Making An 83(b) Election
What’s the catch in opting to pay taxes before appreciation? Well, your granted or exercised shares are taxed as ordinary income in the year you make the election. Once the vesting period is over since you already paid income tax, any gain from selling the stock is considered a long-term capital gain.
Restricted Stock Units (RSUs) vs Incentive Stock Options (ISOs)
When making an 83b election there are different tax rules for RSUs and ISOs. For both, you must make your election within a 30-day window, when the clock starts ticking varies. For restricted stock awards, you need to make the 83(b) election within 30 days after you receive them. For stock options, you make the election within 30 days of exercise.
Example Of Tax Savings With The 83b Election
In this example, we break down the tax perk of 83(b) for startups, compared to not making the election:
83(b) Example Scenario
You are granted a restricted stock award of 10,000 shares in your company, with a fair market value of $1 per share. Your vesting period is 5 years.
If you make an 83(b) election within the first 30 days, you will add the shares to your taxable income for the year. At this moment in time, you are earning a salary of $75K and you are filing as single. See how your taxable income is calculated:
Shares x FMV price
10,000 x $1 = $10K in RSUs
Taxable income + RSUs
$75K + $10K = $85K taxable income for the year
$85K puts you in the 22% income tax bracket
$85K x .22 = $18.7K in taxes
Later when the vesting period ends the price of shares has climbed to $20. Now that they are your property you sell the shares earning $200,000. Since you already paid income tax at the time you were granted the RSUs, you only owe capital gains tax on the profit of $190,000. This would be considered a long-term capital gain because the shares were held for longer than a year. Long-term capital gains tax is a discounted rate of 0-20% depending on taxable income for the year. You are now earning a $150K annual salary, and you are filing as single. See how to determine your capital gains tax threshold:
Taxable income + RSU capital gain
$150K + $190K = $340K
Your capital gain falls into the 15% tax bracket
$190K x .15 = $28.5K in capital gains taxes for your RSUs
If you did not make a timely 83(b) election, you claim $200K as taxable income. See how your RSUs will be taxed below:
Taxable income + RSUs
$150K + 200K = $350K
You are in the 35% income tax bracket
$350K x .35 = $122.5K in income taxes for your RSUs
In total if you make an 83(b) election for startups you will pay $47,200 in taxes versus $122,500 if you don’t.
Note: This is just a scenario and it does not factor in employment taxes, so the numbers aren’t exact. Additionally, typical payouts for vested shares happen on a schedule, rarely would you be paying the full amount of the vested shares in one lump sum. Usually, RSUs will vest over several years, this also affects the fair market value and your taxable income.
Who Should Make An 83(b) Election?
If early-exercisable stock is in your payment plan you should make an 83b election. Here are the people this applies to:
- Board Members
Companies benefit from this election too, although they are not the ones filing with the IRS. When an employee doesn’t make this election, a business has to update the share value at each vesting date according to the FMV at the time of vesting. This has an effect on your income, ergo payroll and employment taxes owed.
How To Make An 83(b) Election?
There is no formal 83(b) election form, instead, you file a written statement. As stated above, depending on the type of stock, you need to make it within a 30-day window of when you are granted or when you exercise your rights to the stock.
See the image below for an example of how to write an 83b election form:
Send your statement to the IRS, and your employer. You will file your 83b election statement with the office where you regularly file. The IRS provides an address to mail your statement in the instructions of your individual tax return. You can find the address for your state office in the “Where Do You File” area of the Instructions for Forms 1040 and 1040-SR.
What Happens When You Miss The 83b Deadline?
Late filing happens, but in this situation is best to be on time since a late 83b is not permitted. But, as long as your company is on board, there are a couple of ways to alter your award/options to still pay fewer taxes:
- Vest your shares immediately: without the holding period, you can pay income taxes right away.
- Transfer amendment to stock options: a transfer of your stock will go to a third party minus a vesting period, where it can be recognized at fair market value.
How To Report An 83(b) Election On A Tax Return
In the year that you made your election, your stock will be reported as income on your tax return. To file 83(b) shares on your tax return, the fair market value of the shares will be reported on a W-2 or 1099-NEC. All you need to do is match the figures from your employer to your tax return. Once the vesting period is over if you sell the shares you are subject to capital gains tax. Any profit/loss earned on the shares must be reported on a Schedule D.
83(b) For Startups: A Rainy Day Fund
Don’t forget about this tax savings opportunity, with your restricted stock awards or stock options. It is an easy oversight and can cost you a pretty penny when your vested shares double the purchase price.