An 83(b) election is a tax provision that enables one to pre-pay taxes on the stock you own from your company as income. In doing so, one can avoid facing a larger tax liability should the stock rise in value in the future. Founders and key members of emerging startup companies frequently make 83(b) elections, given the importance of company stock in their compensation package and the potential for exponential growth in the value of the stock.
Restricted Stock Awards vs. Restricted Stock Units
An 83(b) election is typically filed when the share price associated with an executive’s restricted stock award is expected to appreciate significantly over its vesting period. Restricted stock awards are comparable to restricted stock units (RSUs), which grant employees the right to a specified number of the company’s shares, awarded on the contingency that the employee continues to work at the company until the completion of the shares’ vesting schedule. Both restricted stock awards and RSUs are used to boost an employee’s total compensation package, however, the two are not interchangeable. While RSUs represent stock, the employee does not actually own the stock, nor do they hold any voting rights associated with the stock, until the RSU has been exercised. In unique cases, employees can elect to receive cash in lieu of stock when they exercise.
With a restricted stock award, the employee officially owns the stock when the award is granted rather than when the shares vest. In turn, by immediately realizing their ownership of the stock, employees are granted immediate access to voting rights. In some cases, restricted stock awards require the employee to pay a fee in exchange for the restricted stock. The employee is, in essence, paying for the shares, typically at a discounted rate. As a result, the employee will pay taxes based on the value of the stock less the fee rather than the total value of the stock, reducing their overall tax burden. In addition, where RSUs are taxed as ordinary income based on the fair market value of the shares on the vesting date, restricted stock awards provide owners the opportunity to file for an 83(b) election.
Filing an 83(b) Election
By making an 83(b) election within the first 30 days after receiving the stock grant, ordinary income is recognized and you are taxed on the fair market value of the stock when it is received—the grant date—rather than the date it vests, when the stock is presumably worth more. Being taxed at the grant date also starts the clock for calculating long-term capital gains. Thus, any future appreciation of the stock’s price converts to a capital gain which typically has a lower tax rate (if the stock is held for more than 12 months prior to being sold). This maximizes the value of your holding and lowers your overall tax liability. If you are unable to file an 83(b) in a timely manner, the fair market value of your shares and any appreciation will be subject to your ordinary income tax rate on the share’s vesting date, less the amount, if any, that the taxpayer paid for the stock grant. An 83(b) election does not need to be filed for shares that are fully vested at the time of issuance nor for stock options.
When assessing if it is in your best interest to file an 83(b) election, there are several key factors to consider. First, you are heavily concentrated in company stock, you may want to avoid adding to the risk and exposure that is already inherent in holding a concentrated position. This risk may be offset by the potential for a higher after-tax value of your award by making an 83(b) election.
Second, you should evaluate all expectations for the stock price at the time of vesting. If you are confident the stock price will be higher when the award vests, an 83(b) election may be favorable. However, it is entirely possible the stock price will not increase or may even depreciate, causing you to pay taxes early without realizing any additional benefits. If possible, try to dissociate yourself from any potential biases related to holding company stock when evaluating projections for its share price.
A similar approach should be taken when analyzing tax rates. If higher rates are expected by the time the award vests, depending on the magnitude of the expected tax hike, an 83(b) election may be favorable to you.
An 83(b) election requires one to file a short, written statement with the IRS within 30 days of receiving the stock grant. Usually a single page in length, the statement must contain the following information:
- Your name, address and taxpayer identification number
- A description of the restricted stock award. Of note, 83(b) elections cannot be made with restricted stock units (RSUs).
- The date of grant and tax year for which the election is being made
- Any restrictions on the grant
- The fair market value at the time of grant
- Any amount paid for the grant
- A statement verifying you provided copies of the election letter to the appropriate persons at your employer
While making an 83(b) election is fairly straightforward, the IRS does not provide a standardized form for doing so. Also, no exceptions are made for those who try to file after the 30-day window. To ensure that the filing date is accurately reflected, the letter to the IRS should be sent via certified mail with a request for a return receipt to confirm it was timely received. The statement must be shared with the employer via the Human Resources or Benefits department and should also be attached to the executive’s tax return for the year of the grant.
In addition, filing an 83(b) election eliminates the risk of forfeiture of shares by an employee who leaves the firm prior to their stock fully vesting, or fails to meet certain performance-based milestones that were required in order to own their stock outright. These conditions are common in startups. Typically, if an employee were to fail to meet the required conditions, the shares would be forfeited by the employee and the firm would hold the right to repurchase shares at a discounted price.
Investment advice offered through Shepherd Financial Partners, LLC, a registered investment advisor. Registration as an investment advisor does not imply any level of skill or training. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Securities offered through LPL Financial, member FINRA/SIPC. Shepherd Financial Partners and LPL Financial are separate entities. Additional information, including management fees and expenses, is provided on Shepherd Financial Partners, LLC’s Form ADV Part 2, which is available by request.
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