Understanding the 83(b) Election
Minimizing Tax on Equity Compensation
The 83(b) election is a critical tax consideration for anyone receiving equity subject to vesting, such as employees or founders of a startup.
This provision of the Internal Revenue Code allows individuals to pay taxes on the total fair market value of restricted stock at the time of granting rather than at the time of vesting.
Here's a breakdown of how the 83(b) election works and why it might be a strategic move:
The default rule
Typically, if you receive equity that's subject to vesting, you won't pay taxes until the equity vests.
As such, the tax you pay is based on the stock's value at the time of vesting. This could mean a significant tax bill if the company's value increases over time, as you'll be taxed on the appreciated value of the stock.
This makes sense intuitively. If you can be deprived of a whole or a part of your stock over a period of three or four years, it seems unfair to expect you to pay taxes on the whole amount right at the start.
The 83(b) election
By making an 83(b) election, you opt to be taxed on the entire value of the equity at the current fair market value when the equity is granted even though it is subject to vesting.
This makes sense if we assume that the valuation of the startup will increase significantly over time. This way, you volunteer to be taxed when the company's valuation is low to avoid being taxed on the higher, appreciated value of your stock when it vests at a later date.
This election must be made within 30 days from the date of equity issuance and involves submitting documentation to the IRS and your employer.
The practical effect
Making an 83(b) election can be beneficial if you expect the value of the equity to increase over time.
By paying taxes upfront based on the current fair market value, you could potentially save on taxes in the long run. This is because any future appreciation in the stock's value would be subject to the lower capital gains tax rate rather than the higher income tax rate.
However, there are some other important considerations to be mindful of before making an 83(b) election:
Risk of overpayment: If the company's value decreases after you make the election, you may have paid more taxes than necessary.
Commitment to the company: The election is more advantageous if you plan to stay with the company long enough for the equity to vest.
Financial planning: You'll need to have the financial resources available to pay the tax upfront.
Example scenario
Imagine that Joe, a startup founder, is granted 1 million shares valued at $0.001 each at the time of granting.
Without an 83(b) election, he would pay taxes on the value of the shares as they vest over time. If the company's value increases tenfold at the time of vesting, so does his tax liability. With an 83(b) election, he can pay taxes on the $1,000 total value upfront and any future appreciation is taxed at the capital gains rate.
Takeaway
The 83(b) election is a powerful tool for those receiving equity compensation, offering the potential for significant tax savings. However, it requires careful consideration of the company's prospects, your financial situation, and your commitment to the company.
Consult an attorney or a tax expert before making this election to ensure it aligns with your overall financial strategy.