If you are the founder or an employee of an early-stage company and have stock awards subject to a vesting schedule, then the 83(b) election is going to be a very important tax decision.
The 83(b) election is a section of the Internal Revenue Code that allows individuals with restricted stock awards subject to a vesting schedule to accelerate the taxation of the income. The election is made by submitting a form to the IRS requesting to be taxed on the value of the stock the date it was granted instead of when it would vest.
In what case would you ever want to accelerate the payment of taxes? Here is an example of the 83(b) election in action.
Joe is one of the first employees of a brand new start-up company and as a form of payment for his services Joe just received a portion of his compensation in the form of 10,000 shares of restricted stock in the company. This stock award is subject to a 4-year vesting schedule where Joe receives 2,500 shares every year for 4 years.
The current value of the stock is $0.01, but the feeling is the company will be purchased or go public in the next several years, significantly increasing the value of Joe’s shares.
Joe is now faced with a decision – should he file an 83(b) election. The answer is yes, and here is why.
Joe files an 83(b) election accelerating the tax payment on all 10,000 shares valued at $0.01. The total taxable income in the year Joe received the grant is $100. At a 30% tax rate Joe pays $30 in taxes.
Fast forward 5-years and the start-up company is now going public with an expected IPO price of $25.00. Joe’s 10,000 shares are now worth $250,000 and because he filed an 83(b) election in the year he received the grant, the $249,970 gain is all taxed at long term capital gains rates of 15% at liquidation – a tax liability of $37,495.
If Joe didn’t file the 83(b) election – he would have owed close to $56,250 in taxes over the course of the same 5-year period assuming tax rates remained constant. By accelerating the tax payment when the company is valued at close to zero Joe established basis which allowed all appreciation to be taxed at more favorable rates.
There are situations where the 83(b) election does not make sense. For example, if Joe instead was an employee at a mature private company that already had valuations of $25.00 per share, but there was uncertainty around the future of the company. If Joe did the same 83(b) election at $25.00 per share on 10,000 shares he would have accelerated income of $250,000, paying $75,000 of income on shares he has not even received yet. If time goes by and the company goes bankrupt Joe gets no benefit of the taxes he already paid and his shares are now worthless.
If you or someone you know is receiving company stock as a form of compensation the 83(b) election should be considered, but is not always the appropriate course of action. Please consult with your tax professional or contact your advisor to learn more about the 83(b) election.