Anyone who has stock options, grants or appreciation rights knows that cashing in can have big tax implications in that year. An 83(b) election is a tool for reducing the overall tax by strategically taxing them when granted, instead of when exercised or vested. While it sounds counterintuitive to elect to be taxed in advance of actually earning something, there can be distinct advantages to doing so.
The most common use of this election is with non-qualified options (NQOs). The benefit comes from allowing the gains accrued between the grant and exercise dates to be taxed at the lower rates for long term capital gains, instead of ordinary income. Normally an NQO is taxed as ordinary income on the spread between the strike price and the fair market value (FMV) when the option is exercised. When there is a vesting period after the grant date, the FMV can increase, subjecting the gains during the holding period to tax as ordinary income. Only after the option has been exercised does the holding period begin for capital gain treatment.
An 83(b) election allows the recipient to pay tax upon receiving the grant, deeming it exercised immediately, and starting the clock on the capital gains period (regardless of the actual exercise date). With a potential 19.6% spread (39.6% vs. 20%) in the federal tax rate between ordinary income and long term capital gains, this can make for a substantial tax savings.
For example: an option granted in year 1, with a strike price of $10,000, when the FMV is $50,000, vests in year 2, when the FMV is $100,000. When granted, the option is already carrying $40,000 of income, but increases to $90,000 of income in year 2 when it vests and can be exercised. If the option holder exercises immediately upon vesting, they would pay ordinary tax rates on the $90,000 gain, and still need to hold the shares for an additional year before any further gain would be treated as long term capital. Assuming an ordinary tax rate of 39.6%, there would be a tax of $35,640 in year 2.
If the option recipient in the example above made an 83(b) election upon being granted the option, and exercised in year 2, their total tax would only be $15,840 in year 1 (with an additional deferred $10,000 tax liability due in the year the shares are sold). The result of making the election would be an overall $9,800 tax savings. If the strike price and the FMV were the same at the grant date, an 83(b) election would result in none of the income being subject to ordinary tax rates.
When used, the election must be made within 30 days of the deferred compensation being granted, and must be coordinated with the employer so the income is properly reported. This election can NOT be made after the fact on a tax return. The election can also be used with stock grants, and stock appreciation rights (SARs) to obtain the same results, but cannot be made for an incentive stock option (ISO).
However, there is a risk when making the election. If the FMV decreases after making the election, there is no remedy allowed for the tax paid on income that never occurs. The same holds true if the option is never exercised. As such, while an 83(b) election can be a powerful force multiplier to save on taxes, it does carry some risk of overpaying taxes if the deferred compensation reduces in value, or is never obtained at all.
If you would like to know more about making an 83(b) election please feel free to contact us for a consultation.
Written by Damien Falato, CPA, MST, CGMA, Tax Director