Disclaimer: I am not a lawyer or an accountant. This article was produced with the help of Katy Daiell, Senior Manager at Marcum LLP. Always consult a professional when considering whether or not to file 83(b). Connect with one now.
An 83(b) election as defined by the IRS (hint: it has to do with taxes) “allows a recipient of restricted property to be taxed when the property is transferred instead of when the property actually vests (at a later date when the value may be higher)”. Make sense? End of Post? Well, not exactly. If you ask us, that definition is pretty convoluted. If that’s enough explanation for you, feel free to scroll ahead to the how you file section, but for the rest of us, let’s explain it a bit further.
Let’s start with some basics. There are different types of stock and options that can be granted (ISOs, NSOs, Restricted Stock, etc.) and each has unique tax implications. Depending on what type of shares you were issued and at what point they were issued, you will be subject to different types of taxation. If you are interested in further specifics, Grant Thorton LLP does an excellent job summarizing the tax implications in this whitepaper.
What happens in the case of restricted stock, which is often given to the founders of a company, is that the shares have actually already been transferred to the individual, but they must be returned if he/she doesn’t remain at the company for a specific period of time or for the agreed “vesting” period. (Note: restricted stock is different than stock options, for a good overview of the differences see here). This restricted stock is not reported as income until the year in which the stock vests. What this means is that the founders will need to pay taxes based on the time and value of the stock at vesting. As a result, founders could end up paying substantially higher taxes if the value of the shares increase over the time (which every founder hopes they will do). Cue the 83(b) explanation (finally!).
An 83(b) election allows founders to pay taxes on their shares at the time of transfer instead of the time of vesting since presumably the shares value is much lower at the time of transfer. Note: Section 83(b) elections are applicable only for stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant.
Why does the difference in when you report the income matter? The rate at which you are taxed on the income is different based on whether or not the election is made. When you report the value of the shares, it is taxed at ordinary income rates. An 83(b) election taxes the value at the time of the grant whereas making no election taxes the value at the time of vesting. By making the election, if the value of the shares increase, you will report less taxable income than you would had you not made the election. Later, if/when you decide to sell the shares, the difference between the amount you sell the shares for and your basis (the amount of income you’ve paid taxes on, plus the amount you paid for the shares, if any) is taxed at capital gain rates. Capital gain rates, under current law, are significantly lower.
What exactly is the difference in tax rates? Well, long-term capital gains face a top rate of 20% vs. a top rate for ordinary income of 39.60%. Even more significantly, if you aren’t in the top taxable bracket, you will end up paying much less than that top rate. Taxpayers in the 10 and 15 percent tax brackets pay no tax on long-term gains on most assets and taxpayers in the 25,28,33, or 35 percent brackets face only a 15% rate on long-term capital gains (here’s a helpful chart by Charles Shwab showing the differences).
Put another way, an 83(b) election can save you substantial money in the form of tax dollars. Accelerated Vesting provides a helpful diagram of what failing to file an 83(b) could cost you.
So, does that mean founders who are issued restricted stock should ALWAYS file for an 83(b)? Well, not necessarily. If you receive stock that’s worth nominally nothing, chances are it makes sense to file for one. If the stock has little or no value on the grant date, the income report is $0 or some very small amount which means there is little to no risk in filing for one. However, if you are receiving a large number of shares that are at a higher price, it could cost you thousands up front. Furthermore, if the stock decreases in value, you will have paid more taxes at an ordinary income rate than had you not made the election.
Another potential disadvantage of the election is the risk of forfeiture. If you make the 83(b) election, pay tax on the value of the grant, and later forfeit the stock, you CAN NOT request the money back from the IRS. Essentially then, you are taking a gamble that your shares will be worth more in the future. With 3 out of 4 startups failing, this could end up being a pretty expensive bet. Recipients of restricted stock should carefully consider the advantages and disadvantages before making the election. Here’s a helpful chart on the advantages and disadvantages to filing for an 83(b).
The final question then becomes, how do you file it? Here’s arguably one of the most important things to know. An 83(b) election can only be filed up to 30 days after the grant date of restricted stock and there are NO exceptions to this rule. Even more important to note, the grant date is usually the date that the board approves your grant, not the date that you receive the paperwork for the restricted stock. This means you need to be super mindful of determining whether you are going to file for an 83(b) and ensure you file the paperwork on time.
The steps for submitting for an 83(b) are fairly straightforward:
- Complete the 83(b) Form and cover letter that has been provided to you
- Mail the completed form to the IRS within 30 days of your Award Date- be sure to mail it to the IRS service center where you file your taxes. Be sure to send via certified mail and request a return receipt.
- Provide a copy of the completed form to the company issuing the stock to you.
- Effective in 2016 moving forward, you will no longer need to attach a copy of the completed form to your federal and state personal income tax return for the calendar year that you received the stock.
- Keep one copy of the completed form for your personal statement records and retain the proof of mailing receipt.
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