What Is the Section 83(b) Election? A Guide for Startup Founders
Taxes are one of the few certainties in life, but that doesn’t mean we like to think about them. One of the most common—and most costly—mistakes we see startup founders make is forgetting to account for how their equity is taxed.
On one level, this is understandable. It’s exciting to receive shares of restricted company stock and dream about how much those shares may be worth someday; it’s less exciting to think about how they’ll be taxed. But understanding how restricted stock is taxed can save you serious money, and the Section 83(b) election is central to that understanding.
A Section 83(b) election is a short letter you send to the Internal Revenue Service (IRS) to clarify how you want to be taxed on your equity. In this guide, we’ll review everything a startup founder needs to know about Section 83(b) elections—from how they work to whether you may need to file one. We’ll also show you how filing an 83(b) election could save you thousands (and maybe even more) in terms of your overall equity tax bill.
- What is an 83(b) election?
- How is restricted stock taxed?
- The tax benefits of filing an 83(b) election
- Potential disadvantages of filing an 83(b) election
- How to fill in the Section 83(b) election form
- Final thoughts for startup founders
What is an 83(b) election?
Section 83 of the Internal Revenue Code (IRC) addresses property transferred in connection with performance of services. Section 83(b) is a specific provision of the tax code that gives startup founders and employees the option to pay taxes on the fair market value of their restricted stock at the time it is granted. If you do not file an 83(b) election in time, your stock will be taxed on its fair market value at the time it vests.
In order to inform the IRS that you want to be taxed on the value of your restricted stock at the time of grant, you must file a Section 83(b) election. The Section 83(b) election is a short document that must be sent to the IRS no later than 30 days after receiving your restricted shares—so you can’t simply wait to send it in with the rest of your income tax return.
Why vesting matters
It’s important to note that the 83(b) election applies only to property subject to “a substantial risk of forfeiture.” Restricted stocks qualify because they are subject to vesting.
Vesting means that certain milestones must be met before the recipient is granted full ownership of the stock. This is a common restriction for startup equity. Typically, when a founder or employee is granted equity, they don’t get full ownership of it all at once. Instead, the stock vests based on a vesting schedule. This vesting schedule is often spread out across a period of time (e.g. four or five years) specified in the stock grant. In most cases, if the recipient leaves the company before the final vesting date, they forfeit rights to any unvested stock.
If you don’t file an 83(b) election, your restricted stock will be subject to ordinary income tax on its fair market value at the time it fully vests. Depending on your vesting schedule, it could take your stock years to fully vest. In that time, it’s certainly possible—perhaps even likely—that the fair market value of your stocks will grow.
So, waiting to pay taxes on your shares as they vest means that you will end up paying more taxes if the fair market value of your shares grows over time.
How is restricted stock taxed?
Before we go any deeper, it’s important to pause and review how restricted stock is taxed. Knowing how different tax rates work, and when they apply, can help you make a more informed decision about whether to file an 83(b) election.
Ordinary income tax vs. capital gains tax
Two different types of tax rates that may apply to equity are ordinary income and capital gains.
If you received your restricted stock as part of your normal compensation (i.e. you paid nothing extra to receive it), its fair market value will be taxed at the applicable ordinary income tax rate. It will be considered taxable income regardless of whether you file an 83(b) election or not. Filing an 83(b) election only affects when your stock will be taxed.
Capital gains tax rates apply to profits you make on assets you already own. So, if you own stock that increases in value and you sell it at a later date, you will pay capital gains tax on your profit (the price you sold the stock for minus the price you paid for it).
There are two types of capital gains tax rates that differ based on their holding period:
- Short-term capital gains rates apply to profits you earn from selling assets you’ve held for a year or less. These are typically taxed at the ordinary or regular income tax rate, so they don’t confer any benefits.
- Long-term capital gains rates apply to profits earned from selling assets you’ve held for longer than a year. Long-term capital gains tax rates are lower than ordinary income and short-term gains rates.
Since long-term capital gains rates are lower, these are the rates you want to optimize for if possible. The more your gains are taxed at the long-term capital gains rate, the lower your total tax liability.
The tax benefits of filing an 83(b) election
When you file an 83(b) election, you are essentially fast-forwarding the timeline for when you will need to pay ordinary income tax on your stock.
You can’t get out of paying ordinary income tax, but paying it earlier can make a big difference. There are two beneficial tax consequences of filing an 83(b) election:
- It accelerates the clock on when you owe ordinary income tax. By paying ordinary income tax on all of your shares at the time of grant, you are essentially betting that the value of those shares will increase over time. If you pay ordinary income tax earlier and your shares then increase in value, you will only be subject to capital gains tax on your profits. Conversely, if you wait to pay ordinary income tax as your shares vest, your tax liability will be higher if the fair market value of your shares gradually increases over time. Remember: You pay tax as a percentage of fair market value, not as a set amount.
- It accelerates the clock on when short-term capital gains become long-term capital gains. An added benefit to paying ordinary income tax earlier is that the clock on your capital gains starts earlier. Holding your shares for at least a year before selling them means that your gains will be taxed at the applicable long-term capital gains rate—which is sure to be lower than the short-term rate.
To better illustrate how this all works, let’s walk through a couple of examples featuring a startup founder named Jeanne.
In both examples, Jeanne is granted a restricted stock award (RSA) of 10,000 shares that vest over four years. The vesting schedule in Jeanne’s grant stipulates that 25% of her shares vest each year, assuming she remains at the company. The fair market value of the stock over the course of those four years increases as follows:
Example of taxes owed when filing an 83(b) election
If Jeanne files an 83(b) election within 30 days of her grant, she will owe ordinary income tax on $50,000 ($5 x 10,000 shares).
But how much will Jeanne actually pay in taxes on her equity? The maximum ordinary income tax rate in 2022 is 37%, and the full fair market value of her stock will be subject to this tax rate. This means that she will pay 37% of $50,000, which comes out to an equity tax bill of $18,500.
Now that Jeanne owns her stock and has paid ordinary income taxes on it, any profit she realizes will be taxed at capital gains rates when she decides to sell it.
Example of taxes owed without filing an 83(b) election
If Jeanne does not file an 83(b) election within 30 days of her grant, she will owe ordinary income tax (37%) on her shares as they vest. She won’t pay any taxes on her shares at the time of grant, but she will pay the following taxes on her shares as they vest:
- After Year 1, she will pay $9,250 ($10/share x 2,500 = $25,000) x 37%
- After Year 2, she will pay $13,875 ($15/share x 2,500 = $37,500) x 37%
- After Year 3, she will pay $18,500 ($20/share x 2,500 = $50,000) x 37%
- After Year 4, she will pay $23,125 ($25/share x 2,500 = $62,500) x 37%
Jeanne’s total tax liability without an 83(b) election comes out to a massive $64,750. That means she’s paying $46,250 more in ordinary income tax than she would if she filed an 83(b) election. Yikes!
Potential disadvantages of filing an 83(b) election
In some cases, it may not make sense to file an 83(b) election.
The above examples assume that the value of the stock will continue to increase over time, but this is by no means guaranteed. If you file an 83(b) election and pay taxes on all of your shares at the time of grant, you should understand the risks.
There are two scenarios in which filing an 83(b) election could end up hurting more than helping:
- If the value of your equity falls or if your company goes bankrupt, you may have paid taxes for shares that will ultimately be worth less or—in the worst case scenario—worthless.
- If you decide to leave your company before your shares are fully vested, you will have paid taxes on shares that you never receive. And the prospect of losing shares that you already paid taxes on may compel you to stay at a company even if you’re unhappy. Not a great outcome, all around.
The 83(b) election doesn’t come with a clause that allows you to reclaim any taxes you may overpay at the time of grant, so in both of the above scenarios, you’d have to just eat the cost of the taxes you “pre-pay.”
How to fill in the Section 83(b) election form
You can find the 83(b) form here.
It’s pretty quick to fill in, though you’ll need information about the fair market value of your restricted stock as well as some other information about your stock grant. A few other points to keep in mind once you’re ready to submit the form:
- Plan to make at least three copies of the signed and completed 83(b) form and one copy of the IRS cover letter.
- The original 83(b) form and cover letter go to the IRS along with a stamped and self-addressed return envelope.
- One copy of the completed 83(b) form goes to the company, and one is for your own record-keeping. You may need to attach a third copy to your state personal income tax return. Consult your tax advisor on this before sending it off, as it may not be necessary depending on where you live.
Final thoughts for startup founders
As we’ve demonstrated, the decision to file an 83(b) election is an important one that can result in substantial tax savings. And if you do decide to file an 83(b) election, make sure you do so within 30 days of receiving your stock award. Procrastination is rarely a good policy, but in this case it can make you an extra-grumpy taxpayer.
Oh, and one last thing: It’s always a good idea to consult with a tax advisor if you have questions about the 83(b) election (and even if you think you have it down pat). Some aspects aren’t the most intuitive. For example, the 83(b) election also applies when early exercising stock options, since this produces restricted shares.
If you’re interested in learning more about taxes and equity, we’d love to keep the conversation going. Schedule a call with a Pulley expert today and learn how we can help.
Let's chat about equity
Schedule a call and we'll discuss your equity and see how we can help.