Stock-based compensation and the Section 83(b) election

If you receive restricted stock (RS) as part of your compensation, or options that allow you to exercise them before they vest, consider making an election under Section 83(b) of the Internal Revenue Code.

What is an 83(b) election?

An 83(b) election is a tax election. When you make an 83(b) election with respect to RS or options you receive, you choose to include the value of unvested RS, or the spread of unvested options (the difference between the strike price – what you pay to exercise the option – and the fair market value at exercise), in your taxable income in the year you make the election, rather than in the future when the RS vests or when you exercise your options after they’ve vested – at which point the fair market value and resulting tax liability may be much higher. To make the election, the stock must be subject to a substantial risk of forfeiture before vesting (i.e., you would lose the stock if you left the company before it vested). You should speak to your tax professional before making any decisions.

When to consider making an 83(b) election

Consider making an 83(b) election if:

When do you make the election?

For RS, the election must be made within 30 days of receipt of the RS.

For options, the election must be made within 30 days of exercise. Your company’s plan has to allow you to exercise options before they vest in order to take advantage of the 83(b) election for options.

What happens when you make the election?

When you make an 83(b) election, you elect to include the value of the RS or the spread of the option in your taxable income at that time. Without an 83(b) election, the full value of the RS will be included in your income only when it vests, and the option spread will be taxable at exercise, presumably (in both instances) when the stock price is higher.

As an example, say your company grants you 10,000 shares of RS when the stock is worth $1/share. Those shares vest 25%/year over the next four years. You expect the value of the stock to increase to $5 after one year, to $10 after two years, to $15 after three years, and to $20 in four years when the company goes public.

If you make the 83(b) election, you would include $10,000 (10,000 shares x $1/ share) in your current year’s income. You would be taxed on that $10,000, and your cost basis in the stock would be $10,000. If you hold the stock for at least 366 days, any future gain will generally be subject to tax on sale at long-term capital gains tax rates rather than ordinary income tax rates. If your assumptions about the future stock prices are correct, at the first vesting date, the value of your vesting shares would be $12,500 (2,500 shares x $5/share); at the second anniversary, your vesting shares would be worth $25,000; at the third anniversary, $37,500; and the final tranche would be worth $50,000. You would then own 10,000 shares of stock worth $20/share for a total of $200,000 with a total basis of $125,000.

But rather than paying ordinary income tax on $125,000 over the four-year period (as each tranche vests) and long-term capital gains tax on $75,000 (the embedded gain for tranches 1–3) upon sale of the shares in year four, you would have paid ordinary tax on $10,000 upon making the election and long-term capital gains tax on $190,000 upon sale of the shares in year four (the difference between the value of the shares – $200,000 at $20/share – and the shares’ basis – $10,000) – exchanging often higher ordinary income rates for capital gains rates.

Options work similarly, although you control when you will need to make the 83(b) election (and recognize the income), since the 30-day window is first triggered when you exercise the options. Since employee stock options are usually issued with a strike price that is equal to the stock’s fair market value, it can be beneficial to make an 83(b) election shortly after being granted the option, since you would pay tax on the difference between the market value and the strike price, which in this case would be $0.

Note that you would make a regular 83(b) election for nonqualified options and a special 83(b) election for incentive stock options because in the latter case you would be electing inclusion in the alternative minimum tax. Although in general the result is the same, there are potential risks to making the 83(b) election for Incentive Stock Options (ISOs) if the special ISO holding periods are not met (for example, the business is sold for cash before the end of the holding period). For further discussion of incentive stock options and the alternative minimum tax, please read our publication, WealthFocus on Incentive Stock Options and the AMT.

How do you make the election?

There is no special form for making an 83(b) election. You must send your election to the company and to the IRS office where you expect to file your tax return. The election should say “Section 83(b) Election” at the top; in it, you need to provide the following information:

You do not have to attach a copy of the election when you file your income tax return for that year.

Consult with a tax attorney or other tax professional to help you think through some of the issues regarding your stock-based compensation and the section 83(b) election.

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