What is an 83(b) Election and why do my entrepreneur friends keep bringing it up?
An 83(b) election is an election that you make with the IRS to accelerate the time at which you have to pay income tax on the receipt of stock that hasn’t yet vested. In other words, if you receive non-vested stock as part of your compensation package, by default you will pay tax on the stock (as if it was any other compensation) at the time that it vests. However, if you make an 83(b) election, you can pay the tax when you first receive the stock instead of waiting until it vests.
I thought we like to defer taxes, why would I want to voluntarily accelerate them?
In general, you’re right, we like to defer paying taxes. You’d always rather pay $10 in 3 years than $10 today. However, what if it weren’t so simple? What if your options were to pay $10 in 3 years or $2 today? With stock, this could very well be the case.
For example…
You start to work at Tech Inc as their CTO, and as part of your compensation you receive a 10% ownership interest in the company that does not vest until 3 years from now. Tech Inc is a very young firm and you got in on the ground floor, but that also means that they have very few assets and no revenue to date. Because of this, Tech Inc is only worth $100,000. However, you are hoping it’s valuation will grow rapidly, and 3 years from now you hope to see it approaching $10 million.
Let’s look at the tax consequences in two scenarios, with an 83(b) election and without an 83(b) election:
With an 83(b) election:
You pay tax on the stock you earned, which is worth 10% of the business’s value, or $10,000, as if it were any other compensation. If your ordinary tax rate is 35%, your tax on this earned stock will be $3,500.
Without an 83(b) election:
You don’t have to pay any tax now, but when the stock vests in 3 years, you pay tax on the value of the shares at that time. Let’s say you were right, and after 3 years the company is worth $10 million. Your stock, which is now ready to be taxed, is worth $1,000,000, and your tax on this portion will be $350,000. Keep in mind, you haven’t sold the stock, and this law doesn’t care if you’ve had other earnings or about any outside factors, so you now have to come up with $350,000 in cash to pay the tax on stock that may not have yielded you a single dollar.
But that’s just for earning the stock, what if I sell it?
Selling the stock works the same way whether you made the 83(b) election or not, but you will pay capital gains tax (currently at 15% or 20% depending on your bracket, but subject to change based on the upcoming elections) on a different amount in each scenario. Let’s continue with our previous example, but now we’re in year 5 and you sell your stock for $2 million. You pay capital gains tax on the gain that you recognize on the sale of your stock. Your gain is calculated as your proceeds ($2 million) minus your basis. Your basis will be different in each scenario:
With an 83(b) election:
Your basis is $10,000, the amount on which you’ve already paid tax. Paying tax on that amount gave you basis. When you sell, your gain is $1,990,000, calculated as $2 million of proceeds minus $10,000 of basis. At the current 20% capital gains rate, your tax is $398,000. When you add this to the tax you paid when you received the stock ($3,500), your total tax, having made the 83(b) election, is $401,500.
Without an 83(b) election:
Your basis is $1 million, the amount on which you’ve already paid tax. When you sell, your gain is $1 million, calculated as $2 million of proceeds minus $1 million of basis. Your capital gains tax (at 20%) is $200,000. When you add this to the tax you already paid when you received the stock ($350,000), your total tax, having not made the 83(b) election, is $550,000.
In conclusion…
In our example, making the 83(b) election not only saved you $148,500 in total tax, it also deferred the payment of a significant portion of the tax from year 3 (when the stock vested) until year 10 (when it was sold). It may sound strange, but by strategically accelerating the payment of a small amount of tax early on, you ended up both deferring a large amount of tax and reducing your overall tax burden.
Been paid in stock? Paying employees in stock? Not sure if an 83(b) election is right for you or your team members? Let us know, we can help you navigate this important process!