editione2.1.1
Updated September 12, 2022This section covers one of the most important and complex decisions you may need to make regarding stock awards and stock options: paying taxes early with an 83(b) election.
Generally, restricted stock is taxed as ordinary income when it vests.
If the stock is in a startup with low value, this may not result in high tax. If itβs been years since the stock was first granted and the company is now worth a lot, the taxes owed could be quite significant.
βDefinitionβ The Internal Revenue Code, in Section 83(b), offers taxpayers receiving equity in exchange for work the option to pay taxes on their options before they vest. If qualified, a person can tell the IRS they prefer this alternative in a process called an 83(b) election. Paying taxes early with an 83(b) election can potentially reduce taxes significantly. If the shares go up in value, the taxes owed at vesting might be far greater than the taxes owed at the time of receipt.
βconfusionβ Why is it called an election? Because you are electing (choosing) to pay taxes early in exchange for this treatment by the IRS. Does the IRS secretly enjoy making simple concepts sound confusing? Weβre not sure.
An 83(b) election isnβt guaranteed to reduce your taxes, however. For example, the value of the stock may not increase. And if you leave the company before you vest, you donβt get back the taxes youβve already paid.
βdangerβ You must file the 83(b) election yourself with the IRS within 30 days of the grant or exercise, or the opportunity is irrevocably lost.
βconfusionβ Note an 83(b) election is made on receipt of actual shares of stock. Technically, it cannot be made on the receipt of a stock option itself: You first must exercise that option, then file the election.
If you receive an early exercisable stock option (when you donβt have to wait for the the stock to vest), you can make an 83(b) election upon receipt of the exercised shares.
Section 83(b) elections do not apply to vested shares; the election only applies to stock that is not yet vested. Thus, if you receive options that are not early exercisable (meaning you have to wait until they vest to exercise), an 83(b) election would not apply.
βimportantβ Founders and very early employees will almost always want to do an 83(b) election upon the receipt of unvested shares, since the stock value is probably low. If the value is really low, and the taxes owed are not that great, you can make the election without having to pay much tax and start your capital gains holding period on the shares.
βnewβ With the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, Congress approved a new Section 83(i) that is intended to allow deferral of tax until RSU and stock option holders can sell shares to pay the tax bill. Whether companies will choose or be able to make this available to employees is not clear yet.
When a personβs stock vests, or they exercise an option, the IRS determines the tax that person owes. But if no one is buying and selling stock, as is the case in most startups, then the value of the stockβand thus any tax owed on itβis not obvious.
βDefinitionβ The fair market value (FMV) of any good or property refers to a price upon which the buyer and seller have agreed, when both parties are willing, knowledgeable, and not under direct pressure to carry out the exchange. The fair market value of a companyβs stock refers to the price at which a company will issue stock to its employees, and is used by the IRS to calculate how much tax an employee owes on any equity compensation they receive. The FMV of a companyβs stock is determined by the companyβs most recent 409A valuation.
βDefinitionβ A 409A valuation is an assessment private companies are required by the IRS to conduct regarding the value of any equity the company issues or offers to employees. A company wants the 409A to be low, so that employees make more off options, but not so low the IRS wonβt consider it reasonable. In order to minimize the risk that a 409A valuation is manipulated to the benefit of the company, companies hire independent firms to perform 409A valuations, typically annually or after events like fundraising.