Making an 83(b) election can save taxpayers significant taxes if they purchase or otherwise acquire shares of “restricted” stock in a company that is appreciating in value. Over time, the restrictions attached to these shares “lapse” and the shares become “vested”.
One common restriction is the ability to sell your shares on the open market. Non-vest shares generally can only be sold back to the company at the price originally paid for them. Shares held long enough for the restrictions to lapse, however, are worth their full fair market value and can be sold at your discretion.
Taking ownership of restricted shares of stock is challenging from a tax planning perspective. As the shares vest and the restrictions attached to your shares of stock lapse, you are taxed on the fair market value of those shares on the date they vest.
Let’s say that you provide valuable consulting services to a start-up company, and they offer you the opportunity to purchase 100,000 shares of their stock at a price of 1 cent per share. So your cost is $1,000.
The arrangement is that these 100,000 shares are restricted shares that will vest quarterly over 5 years at a rate of 5,000 shares per quarter, as long as your consulting arrangement continues. If your relationship with the company is severed within 5 years, any shares that haven’t vested can be returned to the company and you will receive the 1 cent per share that you paid. Meanwhile, you’ll continue to own shares that you held long enough to vest, and can sell them at your discretion.
Let’s also say that the day after you purchase the shares, the value of the company jumps to $10.01 per share, and then remains at that value for the next five years. In this case, since 5,000 shares vest each quarter, you will need to report $50k of income each quarter, or $200k of income annually, on your personal tax return. You report this income even though you don’t receive any cash as the shares vest each quarter.
The 83(b) Election to the Rescue:
By making an 83b election, you avoid reporting income each quarter as the restrictions on these shares of stock lapse. Instead, you only report income once; based on the difference between the value of the shares and what you paid for them on the day that you acquired the restricted shares. You’ll report that income the year the shares are acquired.
- Making an 83(b) election provides for lower capital gains when you actually get the money by selling your vested shares (assuming one year passes from the date of the 83(b) election).
- Not making the 83(b) election means the possibility of getting hit with higher tax rates on phantom income as the shares vest since you don’t receive any money for your shares as they vest.
Please note that the larger the disparity between your cost and the shares’ value, the more expensive it is tax-wise to make the 83(b) election. The second major pitfall is that if you make the 83(b) election and then your relationship with the company terminates, you don’t get to take a loss on the 83(b) income reported on the unvested shares.
How to Make the Election:
Usually, if you are working with a start-up company, the lawyer or the finance person helping out the company will guide you through making the 83(b) election.
The election needs to be made within 30 days of receiving the shares of restricted stock by submitting the properly completed and signed election statement to the IRS.
The company also needs to send in a copy of the signed 83(b) election, and you will attach a third copy of the 83(b) election to your personal tax return filed for that year.