The 83(b) election is a provision under the Internal Revenue Code (IRC) that allows employees or startup founders to pay taxes on the fair market value of restricted stock at the time it is granted. This strategic election can help to minimize future tax burdens as the value of the stock appreciates over time.
Key Takeaways
- The 83(b) election is applicable to equity subject to vesting, allowing for taxation at the time of granting, rather than upon vesting.
- Making this election notifies the IRS to assess taxes based on the value at the time of grant.
- By paying taxes upfront, individuals can potentially save on taxes if the share value increases in subsequent years.
How to File an 83(b) Election
The election must be submitted to the IRS within 30 days of the issue of the restricted shares. A copy of the filled election form must also be provided to the employer.
Filing the 83(b) election means pre-paying your tax liability based on the granting-day valuation, potentially saving on taxes if the company’s value grows. Conversely, if the company value declines, one may end up having overpaid in taxes upfront.
Illustrative Example
Imagine a co-founder is granted 1 million shares, each valued at $0.001 at grant time, equating to an initial value of $1,000. These shares are set to vest over five years, meaning the co-founder will receive 200,000 shares annually. If the company’s value increases significantly, the tax liability per year will be higher if no 83(b) election was made.
If in Year 1, the total value of the shares jumps to $100,000, the co-founder’s tax liability calculation would involve:
- $100,000: Year 1 firm value
- $10,000: Original firm value
- 10%: Ownership stake
- 20%: Annual vesting percentage
Formula: ($100,000 - $1,000) x 10% x 20% = $1,980 tax liability for Year 1.
If the share value continues to rise in subsequent years, the taxes will also increase with the revised valuations.
83(b) Election Tax Strategy
A pivotal benefit is opting to pay taxes on the fair market value of stock minus any costs, right at the issuance instead of as the stock vests. By locking in the initial tax basis, future stock value increases won’t incur further income tax – though they might incur capital gains tax upon eventual sale.
Hypothetical Situation
If the co-founder uses an 83(b) election, they could pay taxes based on the initial $1,000 issuance price, avoiding increasing tax burdens over the vesting period.
When sold ten years later for $250,000, taxable gains will be: ($250,000 - $1,000) = $249,000 and it’ll be taxed at capital gains rate.
Benefits of 83(b) Election
- Tax Savings: Tax payments based on the grant date’s lesser value, avoiding higher future rates.
- Favorable Treatment: Future gains taxed at capital gains rates.
- Flexibility: Potentially deductible losses if value declines pre-vesting.
When Is It Beneficial to File an 83(b) Election?
- Expected Value Increase: Ideal when equity is projected to appreciate over time.
- Smaller Reported Income: More advantageous when granted stake’s initial value is low.
What Happens if You Don’t Make an 83(b) Election?
Without election, taxation occurs as the value at vesting date converting significant future benefits into ordinary income tax— possibly leading to higher taxable events annually.
Risks of Filing an 83(b) Election
- Decline in Value: If share value drops or company faces closure, upfront tax result in loss without compensative IRS adjustments.
- Premature Termination: Leaving the company prematurely before the final vesting period ends, may result in unnecessary tax costs.
Example of Downside
If an employee pre-pays $50,000 in taxes (through 83(b)) but vested stock depreciates continually over four years, alternate incremental taxation would have been financially better if the annual declined value resulted in overall lesser taxes.
What Is Profits Interest?
It refers to an equity right based on future profits of a partnership, typically awarded to individuals for their contributions and services without necessitating a capital contribution upfront. Often tied to equity compensation such as via limited liability companies, imposing sometimes a necessity for an 83(b) election.
Conclusion
Choosing an 83(b) election allows paying taxes based on initial lower stock valuation—pivotal in maximizing tax benefits and ensuring strategy aligns particularly for startup scenarios geared for gain. Particularly beneficial in realization compliantly boosting long-term valuation horizons through strategic planning in correlated price rise startups.
With meticulous consideration of pros and impacts, deploying an informed approach renders 83(b) election an advanced tax minimization tactic.
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Related Terms: Restricted Stock, Employee Stock Options, IRS, Tax Liability.
References
- Internal Revenue Service. “26 CFR 1.83-2: Election to include in gross income in year of transfer”, Pages 1-3.
- Internal Revenue Service. “Internal Revenue Bulletin: 2016-33”.
- Internal Revenue Service. “26 CFR 1.83-2: Election to include in gross income in year of transfer”, Pages 1-6.
- Internal Revenue Service. “Topic No. 427 Stock Options”.
- Internal Revenue Service. “26 CFR 1.83-2: Election to include in gross income in year of transfer”, Page 6.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
- JPMorgan Chase. “Stock-Based Compensation and the 83(b) Election”.
