83(b) Election: What Is It and How to Make One

A Section 83(b) election can be a powerful tax strategy for individuals receiving equity compensation. In this guide, we'll explain what a Section 83(b) election is, how it works, and how to decide if it's the right move for you. We will also provide a step-by-step process for making an 83(b) election if you decide to move forward.

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What Is Section 83?

Before diving into the specifics of a Section 83(b) election, it's essential to understand what Section 83 of the Internal Revenue Code covers.

Section 83 governs the tax treatment of property (such as shares or stock) that an employer transfers to an employee or service provider as a form of compensation instead of cash. Under Section 83, property is not taxable until it is no longer subject to a substantial risk of forfeiture or it becomes freely transferable. Once these conditions are met, the recipient must pay income tax on the value of the property.

Equity Compensation Covered by Section 83

There are several types of equity compensation awards that employers can use to reward employees or service providers. Some common types include:

• Non-qualified stock options (NSOs)

• Incentive stock options (ISOs)

• Stock appreciation rights (SARs)

• Restricted stock

• Restricted stock units (RSUs) or phantom stocks

For purposes of Section 83, only restricted stock and direct stock grants are considered transfers of property and are thus subject to tax rules under Section 83. Stock options, SARs, and RSUs are not considered transfers of property until they are exercised or vested.

Vesting and Substantial Risk of Forfeiture

Equity compensation may be subject to various conditions before it is fully owned by the recipient, often referred to as vesting. These conditions create a substantial risk of forfeiture, meaning that the recipient could lose their right to the equity if the conditions are not met.

What Is a Substantial Risk of Forfeiture?

Your equity compensation is considered under a substantial risk of forfeiture if it is subject to conditions related to its transfer, such as time-based or performance-based requirements.

• Time-Based Condition: For example, an employee may need to work for the company for a specific number of years (e.g., four years) before their equity vests.

• Performance-Based Condition: The vesting of equity could also be tied to achieving certain performance milestones, such as meeting sales targets or product launch deadlines.

If these conditions are not met, the employee may lose their right to the equity, which makes it subject to forfeiture.

Transferability Restrictions

In addition to forfeiture conditions, equity awards may also have transferability restrictions—meaning the equity cannot be transferred until certain conditions are met. However, transferability restrictions do not create a substantial risk of forfeiture and do not defer tax liability.

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What Is a Section 83(b) Election?

A Section 83(b) election allows a recipient of equity compensation to choose to be taxed on the value of the equity at the time it is granted, rather than when it vests. By making this election, the employee pays income tax on the current fair market value of the equity, even though it has not yet vested. This can be advantageous if the equity is expected to increase significantly in value over time.

Why Make an 83(b) Election?

• Lower Tax Liability: If you expect the value of your shares to increase, paying tax now (when the value is low) could save you significant money in the future. When the equity vests, any gain will be taxed as a capital gain rather than as ordinary income, often resulting in a lower tax rate.

• Start the Clock on Capital Gains: Filing an 83(b) election starts the holding period for long-term capital gains. If you hold the equity for more than a year before selling, you may qualify for a lower tax rate on any appreciation.

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Factors to Consider

Before deciding whether to make an 83(b) election, consider the following factors:

1. Expected Increase or Decrease in Value: If you believe the value of your shares will increase significantly, an 83(b) election can save you money by allowing you to pay taxes when the value is low. However, if the value decreases, you could end up overpaying on taxes.

   • Example: If you receive shares worth $1,000 today and they grow to $10,000 by the time they vest, an 83(b) election means you pay taxes on $1,000 now, rather than on $10,000 later.

2. Availability of Cash for Taxes: Filing an 83(b) election means paying taxes upfront, which requires having cash on hand to cover the tax liability. If you don’t have the funds available, it may be better to wait until the shares vest.

3. Risk of Forfeiture: If there is a significant risk that you won’t meet the vesting requirements (e.g., you might leave the company before vesting), making an 83(b) election could result in paying taxes on shares you ultimately do not keep. Keep in mind that an 83(b) election is irrevocable—once made, it cannot be undone, even if the equity is later forfeited.

4. Capital Gains Tax Treatment: By making an 83(b) election, you convert future appreciation into capital gains rather than ordinary income. Capital gains are typically taxed at a lower rate than ordinary income, which can lead to substantial tax savings if the equity appreciates significantly.

5. Company's Prospects: If you believe your company has strong growth potential, an 83(b) election may be advantageous. Conversely, if the company's future is uncertain, it might be safer to wait until the equity vests.

How to File an 83(b) Election

If you decide that filing an 83(b) election is the right choice for you, it's important to follow the steps carefully, as the IRS has strict requirements for making the election. The election must be filed within 30 days of receiving the equity grant, with no exceptions.

Step-by-Step Process for Filing an 83(b) Election

1. Fill Out the Election Form

   • Complete the 83(b) election form, which includes your personal information, a description of the equity, the date of the grant, and the fair market value of the equity at the time of the grant. You will also need to state the amount paid for the shares (if any).

   • Make four copies of the completed form: one for the IRS, one for your employer, one to file with your tax return, and one for your records.

2. Mail the Form to the IRS

   • Send the original copy of the election form to the IRS office where you normally file your tax return. Include a cover letter requesting the election and detailing the information provided on the form.

   • Send the form via certified mail with a return receipt requested. This provides proof that the IRS received your election within the 30-day window.

3. Provide a Copy to Your Employer

   • Send a copy of the election form to your employer. This notifies them of your election and helps with their record-keeping requirements.

4. Attach a Copy to Your Tax Return

   • When filing your income tax return for the year of the grant, attach a copy of the 83(b) election form. Note that if you file your taxes electronically, you will need to print and mail your tax return with the attached election form, as the IRS does not accept electronic copies of 83(b) elections.

Important Considerations

• No Extensions: The 83(b) election must be filed within 30 days of receiving the equity grant. There are no extensions, and failure to meet this deadline means you lose the opportunity to make the election.

• Irrevocable Election: Once made, an 83(b) election cannot be revoked, even if the equity is later forfeited. Be sure you understand the risks before proceeding.

Final Thoughts

A Section 83(b) election can be a valuable tax-saving strategy for those receiving equity compensation, but it comes with risks. Understanding the potential benefits and drawbacks, as well as the specific requirements for filing, is essential to making an informed decision.

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