Contributed by: Nicholas E. Gonzalez, CEPA®, CRPS®

The 83(b) election is an essential tax planning strategy that can significantly impact the financial outcomes of business owners, C-suite executives, and founders. This article dives into the specifics of what an 83(b) election is, its tax implications, how it pertains to stock awards, when it should be considered, and the potential outcomes of making this election.

What Is the 83(b) Election?

Section 83(b) of the Internal Revenue Code (IRC) allows individuals who receive restricted stock or other property subject to vesting to elect to pay taxes on the total fair market value of the stock at the time of granting rather than at the time of vesting. This election must be made within 30 days of the grant date, and it can provide significant tax advantages if the stock appreciates in value over time.

Tax Implications of the 83(b) Election

By making an 83(b) election, you pay ordinary income tax on the fair market value of the stock at the time of grant rather than at the time of vesting. This can potentially lower your overall tax burden, particularly if the stock's value increases substantially by the time it vests. This strategy would be important to consider for founders or executives who expect their stock to appreciate, resulting in a substantial income tax benefit. However, if the stock's value decreases or the stock never vests, you won’t be able to claim a refund on the taxes paid at the grant date

Example Scenario:

• Without 83(b) Election: You receive 10,000 shares of restricted stock valued at $1 per share on the grant date. The stock vests after four years, at which point the stock value has risen to $10 per share. You would owe taxes on the $100,000 value at the time of vesting.
• With 83(b) Election: You elect to pay taxes on the $10,000 value at the grant date. Assuming a 35% tax rate, your immediate tax liability would be $3,500. If the stock value rises to $10 per share at vesting, you avoid additional taxation on the $90,000 appreciation, which would only be taxed as capital gains when sold.

Stock Awards and the 83(b) Election

Restricted stock awards (RSAs) are often tied to performance or time-based vesting schedules. By default, RSAs are taxed at their fair market value upon vesting. The 83(b) election gives recipients the option to accelerate the tax event to the grant date, which can be beneficial if they anticipate a substantial increase in stock value.

When Should You Consider an 83(b) Election?

An 83(b) election should be considered under several conditions:

• Early-Stage Companies: If you are part of a startup where the stock value is expected to rise significantly, paying taxes on the lower initial value can be advantageous.
• Long Vesting Periods: The longer the vesting period, the higher the likelihood that the stock value will appreciate, increasing your potential tax savings.
• Low Initial Stock Value: When the initial stock value is low, the ordinary income tax paid upfront will also be lower.

Potential Outcomes of Making an 83(b) Election

Advantages:

• Lower Taxable Income: Opting for the 83(b) election typically results in lower ordinary income tax at the grant date, assuming the stock has appreciated in value.
• Capital Gains Treatment: Future appreciation in stock value will be taxed as capital gains rather than ordinary income, which is usually a lower rate.
• Start Holding Period Early: The holding period for long-term capital gains tax treatment begins at the grant date, not the vesting date.

Disadvantages:

• Risk of Forfeiture: If the stock does not vest, you cannot recover the taxes paid at the grant date.
• Immediate Tax Payment: There is an upfront tax liability based on the grant date value, even if the stock’s value doesn’t increase. Investors must be able to pay this liability from another source, since the shares are not yet vested.

Conclusion

The 83(b) election presents a strategic tax planning opportunity for business owners, C-suite executives, and founders, especially in situations where substantial stock appreciation is expected. Careful consideration of the timing, stock value, and potential risks involved is crucial. Consulting with a Certified Public Accountant (CPA) or wealth advisor can help determine whether the 83(b) election aligns with your long-term financial goals. For more information or to discuss your unique circumstances, schedule a consultation with one of our experienced advisors today.