With tax filing season rapidly approaching, those who own stock options in the companies they work for—or for employees who work for startups who are about to become vested—it’s important to file accordingly. This can be facilitated through a provision known as the 83(b) election, which is part of the Internal Revenue Code.
What is 83(b)?
Specifically, the 83(b) election applies to equity that is subject to vesting. When this election is made, the Internal Revenue Service (IRS) is notified that the elector, whether it be an employee or startup founder, wishes to pay tax for the ownership at the time of granting rather than at the time of stock vesting. An 83(b) election is important due to the ability to pre-pay your tax liability on a lower valuation, assuming any equity value increases in subsequent years. However, if the company’s value declines, this tax strategy would ultimately lead you to overpay in taxes. Typically, whenever a founder or employee receives compensation in the form of equity, the stake is subject to income tax based on its value.
The tax liability is based upon the fair market value of the equity at the time of granting, less any costs of exercising or buying the shares. The tax must be paid in the actual year the stock is issued. In many cases, individuals may receive equity vesting over several years as employees earn the shares from being employed over time. In this scenario, the tax on the equity is due at the time of vesting. If the company performs well and increases in value over the vesting period, the taxes paid during each vested year will also rise in conjunction. An 83(b) election allows someone to pay taxes on their stock awards at the time they are granted, rather than when they are vested. This tax law is often most beneficial to startup employees who may receive large parts of their compensation in the form of restricted stock or stock options. With most startups hoping that their share value will increase rapidly, an 83(b) election allows for major tax savings.
When it’s beneficial
So, when is it beneficial to make an 83(b) election? This election is beneficial to the elector if the restricted stock’s value is going to increase in subsequent years. Along with this, if the amount of income reported is small at the time of granting, this election could be quite beneficial.
When to forego
Alternatively, there are times when an 83(b) election can be detrimental. For example, if the stock value falls or the company goes on to file for bankruptcy, then the elector has likely overpaid in taxes. Note: The IRS does not allow an overpayment claim under this election. Another instance in which this election could be detrimental is if the employee decides to leave the firm before the vesting period is over. This is because the taxpayer has paid taxes on shares they would never receive. Also, if the amount of income reported is substantial at the time of granting, this election may not be beneficial.
For more information, contact the professionals at The Center for Financial, Legal and Tax Planning at 618. 997-3436 or visit here.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. Ian Perry, staff accountant with the firm, co-authored the article.
