Section 83(b) election: maximizing tax savings on stock-based compensation for startups and employees
This article is for informational purposes only and does not constitute legal advice.
Always consult with a tax professional for your specific circumstances.
The Section 83(b) election under the Internal Revenue Code (IRC) can be a powerful tax strategy for employees, founders, and others who receive stock-based compensation with a vesting schedule.
But understanding when it’s worth filing – and the potential drawbacks – is essential.
This guide walks through the basics of the 83(b) election, including when to do form 83(b), the tax implications, the steps to take, and an example to help illustrate the potential tax savings.
What is the 83(b) election?
The 83(b) election allows taxpayers to pay ordinary income tax on the fair market value of stock at the time it’s granted rather than at the time it vests.
This election is generally only applicable to stock subject to a substantial risk of forfeiture, meaning there’s a condition tied to future ownership – like remaining with the company for a certain period or reaching specific performance targets.
Without the election, the IRS taxes the stock’s value at each vesting date, which may result in a significantly higher tax bill if the stock’s value increases over time.
With the 83(b) election, you’re taxed upfront, potentially at a much lower rate.
“Filing an 83(b) election is like betting that the value of your stock will increase – think of it as paying your taxes while the stock is still in its infancy.” - Reid Kopald, EA. Tax Manager
When should you consider filing an 83(b) election?
Consider filing an 83(b) election if:
- You receive restricted stock (RS) with a low fair market value at grant or options with a strike price close to the market value.
- You can afford the tax bill at grant, even if it’s small.
- You believe the stock’s value will significantly increase before the vesting period ends.
- There’s little risk that you’ll forfeit the stock before it vests (i.e., you don’t plan to leave the company early).
An 83(b) election could save you a substantial amount on future taxes if these conditions align. However, if the stock’s value drops after making the election or if you leave before vesting, the election may backfire.
How the 83(b) election works
The 83(b) election essentially “locks in” the fair market value of the stock at grant as ordinary income.
Here’s how it typically plays out:
- You receive restricted stock: Let’s say you receive 10,000 shares at a grant price of $1 each, vesting 25% annually over four years.
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Taxable income at grant: By filing an 83(b) election within 30 days of grant, you choose to recognize the fair market value of $10,000 (10,000 shares x $1) as ordinary income.
Assuming a 37% tax rate, this amounts to $3,700 in taxes. - Capital gains at sale: If you later sell the shares for $20 each, the total gain ($200,000 – $10,000 basis) is taxed at the lower long-term capital gains rate (20%), significantly lowering your tax bill.
Without an 83(b) election, you would have paid ordinary income tax on each vesting date, which could result in much higher taxes as the value of the stock rises.
Example: the tax impact of an 83(b) election
Using a real-life scenario can illustrate the difference in tax burden.
Let’s assume:
- Number of shares: 1,000
- Price at grant: $5 per share
- Price at vesting: $8 per share
- Sale price: $20 per share
No 83(b) election |
With 83(b) election |
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At each vesting date, you’ll pay tax on the full fair market value. Here’s the breakdown:
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If you elect within 30 days of the grant, you pay ordinary income tax on the value at the time of grant:
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“The 83(b) election is ideal when you expect your stock’s value to climb steadily – but be cautious if the stock’s value might dip.”
How to file an 83(b) election
To file an 83(b) election, follow these steps:
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Prepare the election document: Include:
- Your name, address, and Social Security number.
- A description of the property (e.g., 10,000 shares of ABC Inc.).
- Date of the transfer.
- Description of any restrictions on the stock.
- The fair market value and amount paid at the time of grant.
- Send to the IRS: Mail the election to the IRS Service Center where you file your taxes, postmarked within 30 days of the stock grant or option exercise. Consider using certified mail to track the delivery.
- Provide copies to your employer and retain for tax records: Your employer may require a copy, and you’ll need one for your records.
- Include with your tax return: Attach a copy of the election form to your federal income tax return for the year of the grant.
Pro tip. Be punctual! Missing the 30-day window renders the election void, meaning you’ll pay taxes on vesting values instead.
Benefits and drawbacks of the 83(b) election
The 83(b) election can offer substantial benefits, especially for startup founders and early-stage employees, but it’s not without its risks.
Benefits of the 83(b) election |
Drawbacks of the 83(b) election |
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Is the 83(b) election right for you?
The 83(b) election has the potential to change both the ordinary income and capital gains amounts of stock-based compensation. With this election, you hope to recognize less ordinary income and more capital gain income.
Since the highest tax rate for ordinary income in 2023 is 37%, compared to the 20% rate on capital gains, an 83(b) election can result in substantial tax savings if structured correctly.
Pro tip. An 83(b) election isn’t for the faint of heart – speak to your tax advisor to ensure it aligns with your personal situation and financial goals.
For startup founders, early employees, and those receiving restricted stock in emerging companies, an 83(b) election can be a savvy move. Still, careful consideration is essential to avoid paying taxes on shares you may never fully own.
For expert guidance on whether an 83(b) election is right for you, consult with a CPA or seasoned tax professional or who specializes in equity compensation.
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FAQ
No, 83(b) elections only apply to property subject to a substantial risk of forfeiture, such as restricted stock. They don’t apply to stock options unless exercised early and meet specific requirements.
No, once filed, an 83(b) election is irrevocable. Make sure to carefully consider the decision with a tax advisor.
If you miss the 30-day filing window, you cannot make the election for that stock grant. You’ll be taxed on vesting dates instead, potentially increasing your tax burden.
While some employers may provide guidance, it’s the taxpayer’s responsibility to file the 83(b) election with the IRS. Employers are typically not involved in the filing process, although some may request a copy for their records.