Tax, as the old saying goes, is one of just two certainties in this world. While the general truth of that statement is beyond dispute, the amount of tax you pay can be another matter entirely, particularly as it relates to equity awards. For the clued-in and fully informed, there are many mechanisms available that can allow us to reduce our tax bill. Perhaps the healthiest way to look at it is this – let us pay what we have to, but no more than we need to.
With that idea in mind, the Section 83(b) election is a provision under the Internal Revenue Code that allows employees and founders to pay tax on restricted stock awards at the time the grant is made, as opposed to when those shares vest. While there is no guarantee that this will ultimately lead to a lower tax bill, in many circumstances there is a high probability that it will.
The core logic is that with the 83(b) you pre-pay your tax liability at a point when the stock has a low valuation. This, of course, is predicated upon the assumption that the value of the stock will increase over time, and if it does, then, yes, you will certainly be “up on the deal”. Again, there are no guarantees on stock valuation, but making an 83(b) election will be the smart course of action in certain scenarios.
For example, it is not uncommon for startup founders to receive restricted stock early in the life of the business, when that stock has a nominal value. In that situation, it will nearly always make sense to file an 83(b). In essence, the lower the valuation of the stock at the time of the grant, the greater the likelihood that filing an 83(b) will be to your benefit, tax-wise. In such scenarios, if the business gets off the ground, the stock may increase in value by many multiples, and the more that value increases, the better you fare under 83(b), compared to someone with a similar award, but who, instead of being taxed up front, receives a tax ball whenever stock vests.
The best way to show how this can play out is to use an illustrative example. Let’s say a startup founder receives a grant of 500,000 shares, vesting over four years, 25% vest each year, the initial value is $0.05 per share, and that value increases over time (Year 1: $1, Year 2: $2, Year 3: $5, and Year 4: $7).
With an 83(b) election, the founder will pay ordinary income tax on $25,000 (500,000 x $0.05). If we assume their income tax rate is 35%, that translates into a tax bill of $8,750 (35% of $25,000). The increased stock valuation at each vesting point has no taxation implications here, as the full bill has been paid up front. Instead, the founder benefits from accumulating stock of a higher value over the four years and stands to make a tidy profit if/when they sell. More on that later.
Right now, let’s look at how the above scenario plays out without the 83(b) election having been filed with the IRS. No tax bill falls due at the grant moment, but that’s where the good news ends. Any founder or employee who received the same stock allocation – 500,000 shares initially valued at $0.05 – will face a tax bill for each of the four annual vesting moments.
Based on the values offered above, that will look like this:
Ordinary Income Owed
End of Year 1
$125,000 (125,000 shares x $1)
$43,750 (35% of $125,000)
End of Year 2
$250,000 (125,000 shares x $2)
$87,500 (35% of $250,000)
End of Year 3
$625,000 (125,000 shares x $5)
$218,750 (35% of $625,000)
End of Year 4
$875,000 (125,000 shares x $7)
$306,250 (35% of $875,000)
$656,250 (total tax bill over 4 years)
For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.
So, in this hypothetical scenario, filing an 83(b) election leads to an upfront tax bill of $8,750, but no further charges as the stock vests, while not doing so means no upfront charge, but individual bills linked to each of the four vesting moments, each payable at the time, and amounting to a total of $656,250. Perhaps the numbers used in this example are extreme, but the purpose is to communicate the core point – getting hit with a tax bill at each vesting moment can prove expensive, and if you can legitimately avoid those multiple hits, then you owe it to yourself to look very closely at the alternatives, in this case, filing an 83(b) election.
When you look to sell your stock, the 83(b) can again prove advantageous. To be eligible for the lower capital gains tax rate, you need to retain your stock for at least one year – this is called the “holding period.” If you make an 83(b) election, the holding period clock starts ticking from the moment of the grant, whereas without an 83(b) there is a holding period for each individual tranche that vests across the four years.
As stated above, the lower the value of the stock at grant, the more attractive an 83(b). The flip side of that coin is that the higher the stock valuation at grant, the more you will have to think about. It’s not just that the value of the stock may decline over time – in which case you will have effectively overpaid by settling your tax bill upfront – but also, the higher the value of the stock, the greater the tax bill. This latter point may or may not prove problematic, but that will depend upon individual circumstances. The key take home point is this – an 83(b) election makes most sense when a) there is a reasonable expectation that the value of the stock will increase over time, and b) the amount of income being reported arising from the grant is relatively modest, and therefore won’t generate too hefty a tax bill.
Also worth noting is that there is no official 83(b) form. Instead, you write to the company and the IRS flagging your intentions, and as long as you provide all necessary information in a readable format, then your submission should be deemed acceptable. When writing your election, signal clearly at the top of the document that it is a “Section 83(b) Election”. Among the information required is your name, your social security number, the number of shares being granted, whatever restrictions may apply, the fair market value, and the amount to be included in gross income.
The IRS offers more detailed guidance here on how to make an 83(b) election.
This material is distributed with the understanding that it is not rendering accounting, legal or tax advice. Consult your legal or tax advisor concerning such matters. For a complete discussion of risks associated with any investment, please review offering memorandum and speak with your J.P. Morgan Advisor. JPMorgan Chase & Co. and its subsidiaries do not render accounting, legal or tax advice.