How To Do an 83(b) Election
By AJ Ayers, CFP®, EA, CEP
Reader, I have failed you. I could not come up with a clever analogy for an 83(b) election. This elusive and often misunderstood tax rule is straightforward, but due to its extremely tight deadlines, is feared by many.
In its simplest terms, an 83(b) election is a declaration to the IRS that you would like to pay taxes NOW on shares in a company that may go up in value in the future. An 83(b) election literally freezes the taxes and fixes the amount of income that may or may not show up on your tax return. Remember, anytime you receive payment for work you did, the IRS will collect tax on that income. In this case - the difference in price between the grant price of stock or options issued to founders and the current fair market value (often referred to as the spread) of that stock is taxable income.
In other words: ask the IRS to get taxed on your shares when the company is practically worthless (because it hasn’t been built yet) and only pay capital gains taxes on those shares when you sell them in the future.
Most shares in a company, whether issued by the founders to themselves, or to employees later as part of an employee ownership stock plan, are subject to some sort of vesting schedule.
Vesting means that you receive shares over time as long as certain conditions are met. The most common condition is that you still work at the company.
When a company is formed, shares are often issued to the owners at a minuscule value of say, $0.001 per share. If a founder gets 1,000,000 of those shares, they would recognize income of $1,000.
Why Vesting?
Imagine there are three co-founders of a software company, and they own the company exactly equally – in our example, there are 3 million shares. For some reason, they did not put a vesting schedule in place and all of their stock vested immediately. They each pay tax on $1,000 of income (no problem) for their 1 million shares. Now let’s say founder A decides that she doesn’t want to work at the company anymore, let’s say her parent passed away and she feels an obligation to go run the family business. Now that’s obviously very sad and we wish her all the best, except now we have two founders who are working 80- hour work weeks to get this company off the ground and founder A is no longer involved at all. Now they must hire someone to replace founder A who left, and by the way still very much legally and rightfully owns 1/3rd of the company. That’s why we have vesting schedules folks.
Now let’s take that same example above but put in a vesting schedule – meaning that the owners can only actually receive the shares of stock at predetermined times as long as they meet the requirement that they still work at the company.
Let’s assume a simplified 4-year vesting schedule – meaning 1/4th of the shares vest at the one-year anniversary of the grant, 2 year anniversary, and so on. So, employee A bailed six months in and didn’t get squat.
Employees B and C are there to receive their shares on their one-year anniversary and they are stoked. They each get 1/4th of their 1,000,000 shares – so 250,000 shares apiece. So they should just have to pay tax on $250 (250,000 shares times the minuscule par value of $0.001 per share) EXCEPT ONE PROBLEM: this software company is legit and attracted the attention of a major VC firm who already valued their IP at $10 million dollars which means that those 3 million shares have increased in value to $3.33. That’s great news, except now as their shares vest, the IRS wants them to be taxed at the Fair Market Value. This means founders B and C now have a major tax problem: $832,500 (250,000 shares x $3.33) is going to be taxed at ordinary income tax rates (as high as 37%).
How could they have avoided this?
A timely filed 83(b) election would have saved them oh I don’t know (37% x $832,500) $308,025 in taxes. And that’s just the first of 4 vesting events!
So an 83(b) election can often be essential for founders or executives. However, it doesn’t always make sense. In our example, the tax burden at the time the 83(b) election was filed was almost a rounding error because the share value was so low at grant so it’s almost a no-brainer. But we often see scenarios where an executive may be issued restricted stock when the company is already mature, and therefore making an 83(b) election would result in a large tax bill all at once with a substantial risk of the stock never appreciating. Once you pay all that tax, you can’t get it back.
83(b) elections are typically used by early founders or employees who are granted shares of restricted stock that vest over time (NOT RESTRICTED STOCK UNITS OR RSUs).
Why can’t you do an 83(b) election on Restricted Stock Units? Well because you don’t actually get anything until the vesting commences and the IRS says you don’t have to pay taxes on anything you don’t actually own yet. Whereas with Restricted Sock, or Restricted Stock Awards, you do receive all the shares at grant, the restricted part is that you have to meet those pesky conditions and vesting schedule in the future.
How to actually file an 83(b) election
So unfortunately there isn’t an elegant form to fill out or an easy portal to submit online. You’ll actually need to mail a letter to the IRS. There’s no template, you just kinda…do it.
I’ve seen my fair share of 83(b) elections over the years and I always chuckle at how janky and insignificant they seem. It’s just a piece of paper (sometimes it’s handwritten!) but the tax savings can be eye-popping.
The most important part of all of this is that an 83(b) election must be made within 30 days of the grant of restricted stock. No exceptions. If you don’t meet the 30-day deadline, all you have done is accelerated your payment for the stock and the tax will instead be due at each vesting event.
If you’re a founder working with a law firm, chances are your lawyers and tax advisors have told you about the 83(b) election and have maybe even provided a form for you to complete and mail into the IRS.
Step 1: write your 83(b) election. (I think this template is helpful)
Step 2: Mail it to the correct IRS processing office depending on your state. The best practice is to include TWO copies of the letter with a cover letter and a self-addressed and stamped return envelope so the IRS can mail back proof of your 83(b) election.
Are there any downsides?
Of course! Accelerating the tax you owe on shares at a private company is very risky. The company could file for bankruptcy and you could be caught with a tax bill and worthless shares. You could also be fired for cause, meaning you won’t be able to meet the vesting requirements.
What About ISOs? Can you file an 83(b) election for Incentive Stock Options?
You can! This is a new and slightly grey area of the tax code but it’s perfectly legal. When you have a grant of Incentive Stock Options (ISOs) and your company has a written stock plan that allows for something called an Early Exercise, you may utilize an 83(b) election to pay taxes now.
With ISOs, instead of paying taxes on ordinary income when you decide to exercise the shares, your spread between the grant price and fair market value is actually taxed at Alternative Minimum Taxable rates. This strategy is popular with new hires who want to pay all their AMT tax now to not have to worry about large appreciation later.
Imagine this: you just got hired at a software company and are granted 100,000 ISO shares with a 4-year vesting schedule. Now, typically you would have to wait for that vesting schedule to play out - meaning you work at the company for 4 years before you could exercise all of your shares. But if this company’s stock plan allows for an early exercise, then you could exercise ALL of your shares now, file an 83(b) election and freeze the AMT. This could be a glorious tax-saving move if we imagine that the current grant price is exactly equal to the current fair market value of the stock. Say the grant price is $.50 per share and you’ve just been granted the shares - well the company probably hasn’t had a new valuation so the fair market value is also $.50 per share. If you decided to early exercise, you would of course have to pay the strike price of $.50 for your 100,000 shares, meaning you’d have to come up with $50,000 cash, BUT you would pay no tax at all because there’s no spread! So while technically there is AMT due, there’s no difference between your grant price and the fair market value so there’s no income for the IRS to tax. Now you own 100,000 shares and will only have to pay capital gains taxes on appreciation above $.50, assuming you meet the right holding periods of one year from exercise and two years from grant.
But it’s important to remember the 30-day rule here as well, but it’s slightly different. With Restricted Stock as you read above, you have 30 days from the grant to file the 83(b) election, but with ISOs you have 30 days from EXERCISE to file your 83(b) election using the same process detailed above.
An 83(b) election can be a fantastic way to save on taxes, except that it won’t always work out in your favor. Let’s say that your company never goes anywhere any you did end up paying some AMT at early exercise. Well, you’d be out of luck.