For many people, the concept of “buy now and pay later” is straightforward.
It’s the entire premise behind credit cards and what makes them potentially dangerous since you could spend money you don’t have.
But the reverse— “pay now and receive later”— has a much more limited following. It can, however, be a game-changer when it comes to your equity compensation.
Internal Revenue Code 83(b) can have powerful implications for your restricted stock. Making an 83(b) election essentially allows you to pay tax when the award is granted to you and before it vests.
What’s the lowdown on 83(b) elections? How do they work, and are they worth the risk?
What's An 83(b) Election?
With most equity compensation, you have to pay taxes at a few junctures: when your shares vest, after you’ve exercised your shares, and when you sell them. The combination depends on the type of compensation you have.
What if instead of waiting until your shares vest, you could get your tax burden out of the way upfront? Cue an 83(b) election.
An 83(b) election lets you claim ownership when the compensation is granted instead of when it vests. Under this rule, you pay taxes on the fair market value of the award on the grant date.
You can take advantage of an 83(b) election with restricted stock, not RSUs. RSUs represent a promise of company stock at a future date, and since you don’t technically own the RSUs, the IRS doesn’t permit you to pay taxes early.
Tax Consequences of Restricted Stock
To better understand the value of an 83(b) election, consider the traditional tax rules for restricted stock. Restricted stock triggers two taxable events:
- Ordinary income on the spread at vesting (the stock’s fair market value on the vesting date minus the exercise price).
- Capital gains tax on the difference between the stock price on the vesting date and the price at the sale date.
Under current tax policy, ordinary income tax rates max out at 37% while you incur a maximum rate of 20% on long-term capital gains. The 83(b) election is a strategy that aims to have a larger portion of the overall gain from owning the stock taxed at favorable long-term capital gains rates.
How Does an 83(b) Election Work?
If you want to make an 83(b) election, you’ll have to act pretty fast. The IRS gives you 30 days from the equity grant to file. After you notify the IRS, you’ll also need to submit a copy of the form to your employer for their records.
Why would you want to pay tax upfront for a stock that isn’t vested? The ultimate goal is to save you money on taxes in the long run. The hope is that your shares won’t be worth as much when you’re granted them versus when they vest, allowing you to pay fewer taxes on the same asset.
Here’s an example.
Say your company awards you 1,000 shares of restricted stock valued at $1 a share. You have a four-year vesting period, where 25% of the shares vest each year.
You have two choices:
- File an 83(b) election and pay taxes on the total fair market value on the 1,000 shares upfront, or $1,000.
- Pay ordinary income tax on the fair market value of 250 shares each year they vest. Let’s assume that the stock price rises to $3, $5, $6, and $10 throughout the vesting period. By waiting, you’ll end up paying taxes on a higher stock valuation.
With an 83(b) election, your goal is to pay taxes on a lower stock valuation at the grant date and hope your shares vest at a higher price point. You’ll still have to pay capital gains tax when you decide to sell the stock.
Using the example above, if you declined to use the 83(b) election, over the 4-year vesting schedule you would have recognized a total of $6,000 of ordinary income ($3 x 250 = $750, $5 x 250 = $1,250, etc). Choosing the 83(b) and paying $1,000 upfront would mean that the subsequent $5,000 in value from share price appreciation would be taxed at long-term capital gains rates rather than ordinary income rates.
Even if you initially aim to pay less in taxes, you’ll still need to procure the funds to pay the tax bill. Identify the cash flow you’ll use to pay the taxes before rushing into this type of election.
Three Ways Investors Can Benefit From 83(b) Elections.
For those with restricted stock, 83(b) elections can offer some compelling tax benefits.
The most significant is the possibility of minimizing your total tax liability on your restricted stock. By pre-paying at a lower valuation, you set yourself up to enjoy your company’s rising stock prices without incurring the larger income tax hit. Remember, you’ll still need to pay capital gains tax whenever you sell the asset.
83(b) elections are often helpful when investors have a longer period between the grant and vesting dates. Why? Generally, it gives the company time to grow and develop, furthering the opportunity for the stock’s value to increase.
You can likely get the most out of your 83(b) election if your tax liability is minimal at the time of granting. If you have to shell out $200k for an 83(b) election, it may not be worth it. But, if you only have to pay a couple of thousand dollars, it could be something to consider. You just have to make a cash flow plan before you start.
A strategic tax plan can help you get the most out of your equity compensation. By considering your tax options, you can decide what will be best for you in the long run.
83(b) Elections Aren’t Without Risks
83(b) elections aren’t shoo-ins for lower taxes. As you can deduce, this strategy can come with its own set of risks.
The first and perhaps most potent risk is if the stock declines in value. Should the stock price decrease, you would have over-paid for the shares, making it a much less lucrative venture. The IRS doesn’t allow you to claim the overpayment on your taxes to add insult to injury. Once you make an 83(b) election, you’re stuck with it.
This strategy could also be detrimental if the company filed for bankruptcy. Do your best to make sure your company is on solid footing before pre-paying taxes on unvested shares.
You’ll also want to consider your future with the company. If you’re looking to change jobs before your shares vest, you don’t want to pay taxes on something that you won’t get to take advantage of. While the restricted stock is often awarded to more senior directors and executives, your professional goals should influence your decision.
Even if your company is positioned to dominate the market and you have job security, an 83(b) election isn’t always the right move. Since you have to pay the taxes upfront, make sure the amount is reasonable for you. Maybe if you have to pay $100,000 in taxes up front, you’d be better off paying the taxes as your shares vest. Take a look at your cash flow, other forms of equity compensation, and goals before jumping the gun.
Create a Tax Plan That Considers Your Entire Financial Picture.
There is always a risk with the “pay now and receive later” approach, especially with restricted stock, since the future value is ultimately unpredictable.Equity compensation will never be “risk-free,” but nothing in finance is entirely free from risk. It’s all about understanding your relationship with risk, including your risk tolerance and capacity, and building a plan that helps you reach your goals.
We love talking about all things equity compensation and would love to help you chart a productive path forward. An 83(b) election may make sense for you at one point in your journey. Set up a time to talk with us about it today.