The 83(b) election explained
The 83(b) election is a provision in the US tax code that allows individuals who receive property subject to vesting, including equity compensation, to recognize the value of the property as taxable income at the time of receipt rather than at the time the property vests.
However, if the value of the startup declines continuously and consistently, it would mean that you paid tax on equity compensation that is eventually worthless.
When can you exercise the 83(b) election?
When you receive equity compensation, you must pay income tax based on the equity’s value. The fair market value (FMV) of the equity when you received it is the main thing that is considered when assessing tax liability. You also pay tax in the year the equity is transferred or issued.
When employees receive equity compensation, they may have to wait for a certain period of time for the equity to vest. In some cases, they may earn company shares over time, and the tax on that equity value will be due at the time of vesting.
If the startup's value increases during the vesting period, the value of the equity will also increase, which may result in a higher tax liability.
The 83(b) election allows employees to notify the Internal Revenue Service (IRS) to tax the equity at the time of grant instead of at the time of vesting. It must be filed within 30 days of the grant of the equity, and failure to file promptly can result in significant tax consequences.
How does 83(b) election work?
The process of the 83(b) election for stock options is fairly simple. When you receive equity compensation, such as stock options or restricted stock units, you have to determine the FMV of the equity as soon as it is granted. You can do this by getting an appraisal or using a specific formula in the equity agreement.
Within 30 days of receiving the equity, you must file the 83(b) election with the IRS. You have to complete a form and mail it to the appropriate IRS office. There is also an 83(b) election electronic filing available. You should also give a copy of the election to your employer.
Now you are liable to pay taxes on the value of the equity at the time it is granted, even though it may not be vested or sellable yet. This means you may owe taxes even if they have not yet received any cash or stock.
It's important to note that the 83(b) election can have significant tax consequences and should be carefully considered with the advice of a qualified tax professional.
The 83(b) election pros and cons
Like any financial decision, there are both pros and cons to making an 83(b) election. By weighing the pros and cons, employees can make an informed decision about whether or not to make an 83(b) election and understand the potential impact on their tax liability and financial situation.
- Tax certainty: When you file an 83(b) election, it provides certainty about the amount of taxes you owe. This is because the taxes are calculated solely based on the FMV of the equity at the time of the grant.
- Lower taxes: The main benefit of an 83(b) election is that you pay lower taxes on the equity, even if it increases in value. Depending on the type of equity (and the holding period requirements), if you sell the stock options, you are only taxed at the capital gains tax rate, which is much lower than normal income tax.
- Long-term capital gains: The 83(b) election capital gains tax treatment begins when the shares are approved rather than when they vest. This may result in lower taxes if you sell the shares at a profit after the vesting period.
- Paying tax for possibly forfeited or worthless stock: You may pay tax on assets you didn't receive or will eventually become worthless. The 83(b) election can result in taxes being paid on forfeited equity if you leave the startup before the vesting period or on worthless shares if the startup folds.
- Paying tax before receiving equity: Filing an 83(b) election requires you to make a tax payment in the year when you get the shares rather than when you actually receive them.
What are the 83(b) election filing requirements?
After you've weighed the pros and cons of filing an 83(b) election, there are certain requirements that you must follow.
Here's what you need:
- The 83(b) election filing form: To file an 83(b) election, the employee must complete and file a copy of IRS Form 83(b) with the IRS. You must file the form within 30 days of the grant of the equity compensation, and a copy must also be provided to the employer.
- Provide the necessary information: The completed form must include the employee's name, address, taxpayer identification number, the date the equity was granted, a description of the equity, and the FMV of the equity at the time of grant.
- Proof of filing the form: You must keep a copy of the completed form 83(b) and proof of filing/delivery with the IRS. The proof of filing could be a certified mail receipt or an electronic confirmation if you filed the form electronically.
83(b) election: Key takeaways
In conclusion, the 83(b) election can be a valuable tax strategy for employees who receive equity compensation. By making this election, employees can potentially reduce their tax liability and benefit from any future appreciation in the value of the equity.
However, it's important to weigh the potential pros and cons of making the election and understand the filing requirements and potential risks involved. By doing so, they can make an informed decision and potentially benefit from the tax advantages offered by this election.
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