If you’re involved in the startup world, you’ve likely come across the term “83(b) election.” However, you may not have a complete understanding of what it entails or why it’s important. While this article is not intended to provide tax advice, its objective is to help you comprehend the concept and how it may impact you.
An 83(b) election is when a taxpayer decides to pay the taxes in full at the time the stock is granted. Generally, the stock vests over time and would otherwise be taxed gradually as it vests.
So why would you want to make that choice? The answer is below, but first, you need to have a basic understanding of the tax code.
An Overview of the Internal Revenue Code Section 83 and How It Relates to the 83(b) Election
To understand what an 83(b) election is, it’s important to have a basic understanding of Internal Revenue Code Section 83. This section governs property transfers (in our case stock in the startup) in exchange for services rendered.
Startup equity typically has a vesting schedule. Normally, an employee will report only the value of the stock that vested in a given tax year as taxable income. For example, if employees have a four-year vesting schedule, they will report the value of the stock vested in each of those four years.
However, under section 83(b) of the tax code, an employee may choose to include the value of restricted stock as income at its fair market value on the date it was granted, rather than when it vests. This option can be valuable for employees who believe that their company’s stock will appreciate significantly over time.
Making an 83(b) election comes with risks and potential downsides. Therefore, it’s important to carefully consider all options and consult with a tax professional before making this decision.
The Benefits of Making an 83(b) Election
By filing an 83(b) election, employees can lock in their tax liability at the time of the stock grant or purchase, instead of waiting until the stock vests. This can help employees reduce their overall tax burden. By paying taxes on the value of the stock when it is granted or purchased, they may avoid paying higher taxes later when the stock vests and potentially increases in value.
For example, let’s say you join a startup and are issued 100,000 shares that vest over four years at a fair market value of $0.01/share. The company does well, and the stock value increases. Yay! In year two, the stock price is $0.10/share; in year three, it is $1/share; in year four, it is $2/share.
If you did not make an 83(b) election,
- In year one, you are paying taxes on ordinary income of $250 (25,000*$0.01)
- In year two, you are paying taxes on ordinary income of $2,500 (25,000*$0.10)
- In year three, you are paying taxes on ordinary income of $25,000 (25,000*$1)
- In year four, you are paying taxes on ordinary income of $50,000 (25,000*$2)
If you made the 83(b) election, then you pay taxes on $1,000 (100,000*$0.01) on the year it was granted, and you pay no taxes in years two to four.
How to Make an 83(b) Election: Required Steps
To make an 83(b) election, follow these straightforward steps:
- Get the necessary forms: Start by obtaining the appropriate forms for the 83(b) election. Although it’s not required, startups often include an 83(b) form along with the stock grant. This is sometimes, but not always provided by the company.
- Fill out the forms: Once you have the forms, ensure you are accurate and thorough when completing them. Provide information about yourself, your employer, and the stock grant or purchase.
- Submit the forms to the IRS within 30 days: After completing the forms, send them to the IRS within 30 days of receiving the stock grant or purchase. It is crucial to submit on time because failing to do so can result in significant tax penalties. You have a firm 30-day window, and missing this opportunity means it’s gone forever.
Common Misconceptions About 83(b) Elections
Despite the advantages of making an 83(b) election, there are still some common misunderstandings that can cause employees to forgo this option. Here are some of the most widespread misconceptions:
Misconception #1: You only need to file an 83(b) election if you’re receiving a large amount of stock.
This is not accurate. Whether you’re receiving a small or large amount of stock, it’s important to consider making an 83(b) election. Even if the value of the stock is low at the time it’s granted or purchased, it may appreciate significantly over time, resulting in a higher tax liability later on.
Misconception #2: You can make an 83(b) election at any time.
This is also incorrect. To be valid, an 83(b) election must be filed within 30 days of receiving the stock grant or purchase. Failing to file on time can result in significant tax penalties and may even render the election invalid.
Misconception #3: Making an 83(b) election means you’ll have to pay taxes twice.
While it’s true that making an 83(b) election involves paying taxes on the value of the stock at the time it’s granted or purchased, this does not mean that you’ll have to pay taxes again when it vests. By filing this election, you’re simply locking in your tax liability at the initial value of the stock rather than waiting until it vests and potentially increases in value.
Misconception #4: Only high-level executives should make 83(b) elections.
Again, this is not correct. Any employee who receives equity as part of their compensation package can benefit from making an 83(b) election—regardless of their position within the company.
By understanding and dispelling these common misconceptions about 83(b) elections, employees can make more informed decisions about whether or not to take advantage of this valuable option. As always, consulting with a tax professional is recommended before making any decisions related to taxation and investments.
Of course, companies and employees should consult with legal counsel to fully understand how this impacts their specific situation. If you are looking for legal counsel, feel free to reach out to us here.
