What is an 83(b) election?

Equity based compensation such as options or restricted stock has grown tremendously in popularity in recent years. For startups and small businesses, equity can be a valuable and effective means of compensating key employees (and incentivizing retention) during early growth periods when cash flow is tight. We are frequently asked by clients to help determine whether it makes sense to make an 83(b) election on restricted stock. In almost all cases, it is better to recognize compensation in the year of the grant by making the election. However, code section 83(b) has strict rules and a tight deadline to ensure the election will stick.

What are the rules?

The value of property, including stock, options, etc., that your employer transfers to you as compensation for your services is includible in your gross income either in the first tax year in which the property is not subject to a substantial risk of forfeiture (i.e. after the vesting period), or when you can transfer the stock free of the substantial risk of forfeiture, whichever occurs earlier.

For example, say you will be entitled to 1,000 shares of stock if you complete two years of employment following the date on which restricted stock is granted. Under the tax rules, you can either defer the income attributable to the grant of this restricted stock until your rights in the stock become vested, or elect (by making a Code Sec. 83(b) election) to recognize income at the time the stock is granted. The amount of the income recognized as a result of the election is based on the fair market value (FMV) of the shares on the date of grant. FMV is usually set by the employer (or an outside appraiser) after performing a 409A valuation.

A Code Sec. 83(b) election must be made within 30 days of the grant of restricted stock by informing both the IRS and your employer. This is a hard deadline that the IRS has consistently declined to waive or extend except in extraordinary cases.

Why make the election?

The advantage of accelerating income through a Code Sec. 83(b) election is that you won’t be taxed on any future appreciation in the stock until you sell the stock, at which time any gain will be taxed at long term capital-gain rates. Furthermore, since many companies offering stock are early stage startups, the value of the stock recognized as ordinary income may be extremely low (often only a fraction of a cent per share).

If you don’t make the Code Sec. 83(b) election, you will be treated as receiving taxable income equal to the stock’s FMV on the date the restrictions lapse.

Here’s an example of how a making Code Sec. 83(b) election can be advantageous. Assume that you are granted 1,000 shares of restricted stock in Year 1, when their value is $100 per share. The restrictions on the stock lapse in Year 2, when the stock is worth $160 per share. You sell the shares in Year 3 for $200 per share. In that case:

• If you don’t make a Code Sec. 83(b) election, you will be taxed on $160,000 of ordinary compensation income in Year 2 and $40,000 of capital gain in Year 3.
• If you make the Code Sec. 83(b) election, you will be taxed on $100,000 of ordinary compensation income in Year 1, and on $100,000 of capital gain in Year 3.

The benefit of the Code Sec. 83(b) election to you, on the above assumed facts, is twofold. First, the tax on the $100,000 post-election increase in the value of the stock is postponed until Year 3. Second, the entire $100,000 of appreciation is taxed at long term capital gain rates. Only $40,000 would be taxed as capital gain if no election had been made. Under current federal law, the highest long term capital gain rate is 20% vs. 37% for ordinary income.

The rules governing restricted stock awards are technically complex and call for careful tax planning. Please contact us if you would like to discuss this matter in more detail.