The Ultimate Guide to Understanding the 83(b) Election: Everything You Need to Know
If you’re an entrepreneur or startup founder, you have probably heard about the 83(b) election. But do you know what it is and how it works?
The 83(b) election is a tax provision under the Internal Revenue Code that allows an employee or service provider to convert restricted stock units (RSUs) or stock options into actual stock and pay taxes on the current value of the stock instead of the future value.
In this ultimate guide, we will explore everything you need to know about the 83(b) election, including how it works, its benefits and drawbacks, how to file it, and real-life case studies to help you make an informed decision.
How Does the 83(b) Election Work?
The 83(b) election applies in situations where an employee or service provider receives RSUs or stock options that are subject to vesting. Vesting means that the stock or options are granted over a period of time and that the recipient must satisfy certain requirements, such as staying employed with the company or achieving certain performance metrics, before they can exercise or sell the stock.
Typically, when RSUs or stock options vest, the recipient must pay taxes on the difference between the current fair market value (FMV) of the stock and the strike price (the price at which the stock can be purchased).
However, if the recipient makes an 83(b) election, they can pay taxes on the current FMV of the stock based on the date of the grant, rather than the date of vesting. This means that if the stock increases in value after the grant date and before the vesting date, the recipient will not have to pay taxes on the increase in value.
What Are the Benefits and Drawbacks of the 83(b) Election?
The main benefit of the 83(b) election is that it can result in substantial tax savings if the stock increases in value. By paying taxes on the current FMV instead of the future value, the recipient can avoid paying taxes on the appreciation of the stock.
Moreover, the 83(b) election can reduce the risk of being hit with a large tax bill if the stock increases in value significantly, which can happen if the company goes public or gets acquired.
However, the 83(b) election is not without its drawbacks. For one, it requires a significant upfront payment, especially if the stock has a high FMV. Additionally, if the employee leaves the company before the stock vests, they will not be entitled to a refund of the taxes they paid.
How Do You File the 83(b) Election?
To make an 83(b) election, the employee must file a written statement with the Internal Revenue Service (IRS) within 30 days of receiving the stock.
The statement should include the following information:
– The name, address, and taxpayer identification number of the employee
– A description of the property (stock) for which the election is being made
– The date on which the property was transferred to the employee
– The nature of the restrictions on the property
– The FMV of the property at the time of transfer
– The amount paid for the property (if any)
– A statement that the election is being made under section 83(b) of the Internal Revenue Code
– The taxable year for which the election is being made
The statement should be filed with the employee’s tax return for the year in which the stock was granted.
Real-Life Case Studies
To better understand how the 83(b) election works, let’s take a look at some real-life case studies.
Case Study 1: John works at a startup that grants him 10,000 RSUs at a strike price of $1 per share. The current FMV of the stock is $5 per share. John makes an 83(b) election and pays taxes on $50,000 (10,000 x $5) at the grant date. When the stock vests, it is worth $10 per share. John sells all his shares for $100,000 (10,000 x $10) and pays long-term capital gains tax on the difference between the sale price and the grant price, which is $90,000. If John hadn’t made the 83(b) election, he would have paid taxes on $9 per share (the difference between the FMV at vesting and the strike price) and would have owed ordinary income tax on the difference between that amount and the sale price, which is $81,000.
Case Study 2: Sarah works at a company that grants her 5,000 stock options at a strike price of $1 per share. The current FMV of the stock is $10 per share. Sarah makes an 83(b) election and pays taxes on $50,000 (5,000 x $10) at the grant date. When the stock vests, it is worth $12 per share. Sarah exercises her options and sells all her shares for $60,000 (5,000 x $12) and pays long-term capital gains tax on the difference between the sale price and the grant price, which is $10,000. If Sarah hadn’t made the 83(b) election, she would have paid taxes on $1 per share (the difference between the FMV at vesting and the strike price) and would have owed ordinary income tax on the difference between that amount and the sale price, which is $55,000.
Conclusion
The 83(b) election can be a powerful tool for employees and service providers who receive RSUs or stock options that are subject to vesting. By paying taxes on the current FMV of the stock, they can avoid paying taxes on the appreciation of the stock, which can result in substantial tax savings.
However, the 83(b) election is not without its drawbacks, and employees should carefully consider whether it makes sense for their specific situation.
If you’re considering making an 83(b) election, be sure to consult with a tax professional who can help you navigate the complexities of filing and ensure that you make the best decision for your personal financial situation.
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