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?
When you make an 83(b) election with respect to RS or options you receive, you choose to include the value of RS, or the spread of the 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 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 (e.g., you would lose the stock if you left the company before it vested).
When to consider making an 83(b) election
Consider making an 83(b) election if:
- You receive (i) RS with a low market value per share at the time of grant or (ii) options with a strike price that is close or equal to the market value per share
- You can afford to pay any costs associated with the election (you will have to pay the strike price for options, and any income tax generated by making the election for both RS and options)
- You believe the value of the company’s stock will increase significantly over time
- The risk that you will forfeit the stock is small (i.e., you don’t expect to leave the company and, as a result, forfeit the stock)
- You believe you will be able to sell your stock later at a higher price
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. You should confirm that your company’s plan allows you to exercise options before they vest.
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 they vest, 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. Since you didn’t pay anything for the RS, your 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.
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 $0.1
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 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:
- Your name, address and Social Security number;
- A description of the property (e.g., 10,000 shares of common stock of ABC corporation);
- The date you received the property and the year for which you are making the election;
- The nature of the restrictions on the property (e.g., forfeit if employment terminates before vesting);
- The amount, if any, you paid for the property; and
- A statement that you have provided copies of this 83(b) election as required by the law.
You do not have to attach a copy of the election when you file your income tax return for that year.
Consult with your J.P. Morgan Advisor and your attorney or CPA to help you think through some of the issues regarding your stock-based compensation and the section 83(b) election.