83b Election Basics
Posted Sun, September 30, 2018
An 83b election is a letter you send to the IRS electing to be taxed on the day the stock was granted to you, versus when the stock vests. This might not seem like a big distinction, but it can be huge. The distinction lies in the difference between ordinary income tax rates and long-term capital gain rates.
- 100,000 shares subject to vesting
- $0.01 value per share at time of grant
- $1.00 value per share at time of vesting
- $5.00 value per share when sold
83b Election Filed
An 83b election must be filed within 30 days of the grant date, and this is usually the date the board of directors announces the grant. It might be several days later before the employees are aware which eats into the 30 day limitation.
The IRS will stamp the letter and mail it back to you. This letter is now worth a lot of money if you need to present it to the IRS later during an examination. Treat this like gold. Put it in a freezer and then put the freezer inside of a safe. Conversely, perhaps a safe fits better in a freezer.
- When the stock is granted, it is worth $1,000 (100,000 shares at $0.01). You will pay ordinary income taxes on this amount. Done. No biggie.
- When the stock vests, it is worth $100,000 but you pay nothing.
- When you sell the stock, it is worth $500,000 and you will pay long-term capital gains with a basis of $1,000 provided you sold it one year after the grant date (as opposed to the vesting date).
Ordinary income tax on $1,000 and capital gains tax on $499,000.
No 83b Election Filed
Using the same example above, the math changes to your detriment.
- When the stock is granted, it is worth $1,000 but your do not pay income taxes on this amount.
- When the stock vests, it is worth $100,000 and you pay ordinary income taxes on this amount. Yuck.
- When you sell the stock, it is treated the same as if you had filed the 83b election but the basis is $100,000.
Ordinary income tax on $100,000 and capital gains tax on $400,000. Note the difference from above.
83b Election Benefits
Comparing these two examples results in a $19,000 tax savings by filing the 83b election assuming you are in the 39.6% marginal tax rate. The timing of the tax hit is also critical. At the time of grant, the tax bill was $396 with the 83b election without a tax hit at vesting. Conversely, without the 83b election the tax hit was delayed until vesting, but was $39,600 at a time when you might not have the cash laying around. And you don’t want to be forced to sell it early especially if it rocketing in price.
The 83b election also starts the holding period earlier, at the grant date.
Most employees file the 83b election. But there might be a time when that doesn’t make sense. For example, if the same shares were worth $100,000 at grant date, filing the 83b election would immediately cause a $39,600 tax obligation (again assuming you are in the 39.6% marginal tax rate). It could get worse- the company’s stock could fall in price prior to vesting, you might have tremendously overpaid taxes.