What Is An 83(b) Election and When Do I Make It? [Part 1 - With Graphic!]

What’s an 83(b) election, and when is it a good thing to do? Great question, and one every entrepreneur, founder, contractor, or anyone else trading work for equity should know the answer to. In this two-part post, I’ll first explain what the 83(b) election is, then I’ll walk through a situation where making the election makes good sense, and in the second installment I’ll walk through a situation in which making the election wouldn’t make sense (and some other considerations that might prevent you from making it). And with that, off we go.

As a basic starting point, when you’re given equity in a company as compensation you have to pay taxes on it the same way you have to pay taxes on any other income. When it comes to how much you pay, the IRS is going to calculate your tax liability based upon the fair market value of the equity at the time it’s transferred to you. When it comes to when you’ll pay those taxes, the IRS is going to require you to pay tax on the income during that year in which the equity is actually transferred to you such that you could do what you want with it.

Very frequently though, especially with founders, any grant of equity is going to be subject to a vesting agreement. What that means is that under the default rule, you don’t pay taxes on any stock until it actually vests, and you pay taxes based upon the value of the stock at the time of vesting. As a practical matter, what this means is that if the company does really well and goes up in value over the course of the vesting agreement, you’re going to end up paying more and more taxes over the years.

The IRS has implemented another option, though, the 83(b) election. Codified at 26 U.S.C. § 83(b), this election lets you decide at the start of your vesting agreement to be taxed for the entire amount that will eventually vest at the present value. Rather than paying tax each year then, you pay all the tax up front based on the value of the stock when it was granted to you. In order to make this election, you have to send a letter to the IRS within 30 days of the grant being made. The IRS has published a sample letter that outlines all the information needed.

This can all get a little confusing, so when does it make sense to take this election, when will it save you tax money? Well, one situation where it usually makes a lot of sense to take the election is where you’re a founder of a brand new company with no real value, and you’ve agreed to a multi-year vesting agreement. In such a situation, you pay tax up front on all the shares when they’re valued basically at nothing. You only pay tax again when there’s some kind of liquidation event. As long as that event comes more than a year after the grant, you’ll end up paying taxes at the long-term capital gains rate, which is a lot lower than the typical income tax rate, and you come out way ahead.

To spell this out a little more clearly, I’ve put together a graphic outlining the tax liability that you’d encounter in this situation, under both the default rules and with the 83(b) election. For the purpose of the graphic, assume:

  • Brand new company with two founders;
  • Each founder is granted 1,000 shares on a two year vesting plan;
  • Price per share at founding is $0.01;
  • Income tax rate of 33%, long-term capital gains rate of 20%.

So here it is:

IRS Section 83(b) Table

As you can see, the difference in ultimate tax liability, and in what you have to pay each year (especially if you haven’t actually been paid any real money yet) can be huge in a situation like this and so it’s crucial to understand what the 83(b) election is and make sure you get it done.

[Update] Check out Part 2, in which I go through a scenario where the 83(b) election doesn’t make sense.

*A special shout out to Gerrit Betz, an excellent startup attorney in his own right, for taking the time to offer his insight and double check my math.*

Comments

  1. This article is completely wrong. An 83(b) election allows you to be taxed on the difference between the purchase price and the fair market value.

    • Hey Joe,

      Thanks for the feedback, though of course I disagree. As a practical matter, you’re always getting taxed on the difference between the purchase price and the fair market value, because the IRS will look at any difference as income. What the 83(b) does is allow you decide up front that you want that difference calculated as of the date the restricted stock agreement or vesting schedule is signed (because presumably the fair market value will be very low at that point and you’ll therefore owe very little, if anything, in taxes), rather than as of the date you actually get the ability to do something with that stock (ie. the vesting date). Hope that helps clear up any confusion.

      Of course, if you still think I’m wrong, I’d really appreciate it if you’d point me towards the rules you’re relying on to make that assessment. Either way, thanks for reading!

      -Steve

  2. Hi Steve, Thanks for taking time and sharing this info. with everyone – especially the graphic makes everything very clear. I received some equity in 2012 year but didn’t file for an 83B election during filing my taxes in 2013. Going by your article I should have filed for an 83B election…the share value was very low. Although, the share value hasn’t changed much since then (rather it hasn’t changed at all) can I still file for an 83(B) election now in 2014 for my 2013 taxes or should I go back and amend my 2012 taxes Or have I lost the opportunity as you mentioned that I have to send a letter within 30 days What’s the best possible route now? Thanks again!

    • Unfortunately, you have to notify the IRS by filing an 83(b) election within 30 days of the grant (which is usually the date on which you sign the vesting agreement/restricted stock agreement), so there’s not a way to go back and amend previous year tax returns and file late.

      With regard to your particular situation, there may be some strategies around ending the current stock transfer agreement (where everything hasn’t vested yet), and entering into a new one that you could file an 83(b) on, so shoot me an email or give me a ring if you want to discuss your individual matter and what might be done.

  3. How does an 83b election work in the case of an option grant? My situation is I will have an option grant that vests over 4 years.

    • Great question! The first thing to distinguish between is vesting on an option grant, and vesting on a stock grant. When a stock grant vests, that means you’ve got real honest-to-goodness stock that you can sell if you want. You’ve got an asset. When an option grant vests, it means that you now have the option of buying stock, you don’t really have anything yet. So, the 83(b) election applies when you have stock vesting on a schedule, but not when you have options vesting on a schedule. As a general matter, option grants and 83(b) elections have nothing to do with each other.

      The important exception to this rule has to do with early exercise of option grants. That is, sometimes when you have an option grant that vests over several years, you’ll have the further option to exercise your right to purchase early. Usually when you have that option, what you end up buying by exercising early is restricted stock. That means that you buy this restricted stock, but if you quit or leave the company before your vesting date, the company pays you back for the stock and you get nothing. If you stay beyond the vesting date, the restricted stock converts to common stock.

      If you’ve got this option, then the restricted stock will generally turn into common stock on the same schedule as the vesting schedule for your options. Since you’re now in a situation where it’s stock that’s vesting on a schedule and not options, you’re now eligible to file an 83(b) election, and all the regular 83(b) rules apply (including the 30 day window in which to file).

      Hope that’s helpful!

      • Very helpful! Thanks for the information!

        • Following up on John’s question:

          I have an option grant that vests on a 4 year schedule with an initial 1 year vesting cliff, and I intend to immediately exercise the options as they vest (i.e. 1/4 of the total options exercised at the end of year 1) to start the clock on the long-term cap gains holding period. Can I submit an 83(b) election on the exercised options when they are exercised (i.e. 1 year +1 day from initial option grant), or was I required to submit this election a year earlier when I received the option grant?

  4. Steve,
    Please let my thanks as well. It appears from what I’ve read and seems to be confirmed here, is that if the person getting the stock didn’t make the election in the first 30 days, there is no excuse, you missed the boat.
    Have I got that right?
    Henry Marcus

    • That’s correct, the IRS is very strict about the timeline, and if you don’t make the election on time you’re out of luck. For that reason, it’s always important to make sure you get proof of filing. At a minimum that means sending the document certified, but you can also send the IRS a self-addressed stamped envelope and ask them to date and time stamp the filing and send you a copy back as well.

      • If you are a private consultant and are given the tax in lieu of payment for services, won’t you also have SE tax?

      • Hi Steven,

        I really like your clear graphics showing the consequences of the 83(b) election. I am hoping there is a misunderstanding regarding the timing of the 82(b) election and stock option grants/exercise. I found this excerpt regarding the 30 day window in Internal Revenue Bulletin 2012-28, “.05 Under § 83(b)(2), an election made under § 83(b) must be made in accordance with the regulations thereunder and must be filed with the Internal Revenue Service no later than 30 days after the date that the property is transferred to the service provider…” The phrase I am hung up on is “property is transferred”. Is a stock option grant a property transfer? What if the fair market value is still equal to the option price when the option is exercised? It would seem that no property had been transferred until the option was exercised. It is about 38 days since I got my grant, but the prevailing wisdom at my company is that the 30 days starts at the time I purchase the stock. Can you point me to any IRS document that spells this out clearly (one way or the other) for incentive stock option grants?
        Thanks.

        –Charlie

  5. So, if you are a founder and just registered a company with no vesting period for your stocks, 83(b) does not apply?

    • That’s correct, if the stock is granted without any restrictions, then it’s going to be counted on the current year tax return no matter what, and the 83(b) election doesn’t apply.

      • Mark Diehl says:

        assuming you correctly and timely filed the 83(b) election, where on the 2013 tax return would you report the income and is it subject to SE tax.

        Thanks for your response and a very informative discussion of the issue.

      • so, if you are a founder with stock with no vesting period, then you only pay tax when there is a liquidation event correct? No need to pay every time the stock is valued?

  6. Please explain the math you use in example 1 and 2 for the 83b election column. For example, $200,000 of income taxed at 33% becomes more than $66,000. I believe here you are using a rate of 1/3 rather than 33.0%

    For example 1, you get to $3.00 in tax assuming 1000 shares * $0.01 FMV, but that would seem to imply a 30.0% tax rate.

    Also, this is based on “grants” of equity. If the founders paid cash for their shares in the amount of the par value, their taxes owed would presumably be zero; this is not highlighted in your article. Is there a reason for that?

  7. Hi. I filed my 83(b) several days ago which was within 30 days. Then today I noticed I’ve filed it to a wrong address. I am a non-resident, so I should file it to the IRS at Austin, but, mistakenly, I filed it to the IRS at Kansas. 30 days has passed since we sign the agreement. Are there anything I can do? Thanks.

  8. Thanks for this. Very helpful. Quick clarifying question…

    In the 83(b) example, wouldn’t your long-term capital gains actually be three bucks lower?

    I.E. your LT gain would account for your initial basis – so your gain is really ($150 selling price LESS $0.01 grant price (on which you’ve already paid $3.00 in tax and thus is not subject to tax again)) X 1,000 shares = $29,998.

    Add to that your initial $3.00 tax payment and your 83(b) election example has a total tax bill of $30,001… or am I missing a key detail?

    A second question re: options: If someone has options that vest over time, and upon exercise of those options the Company retains right of first refusal, does that impact how the IRS would treat the shares received through exercising the option? I.E. If I exercise my option to purchase 1000 shares of a privately held company, do I have to pay the IRS anything at all if I cannot legally sell those shares without jumping through hoops?

    • I am a hr manager for a company that offers restricted shares. When an employee elects a 83(b) option with restricted shares what do I report in payroll or do I just need to make sure it shows up on their W-2? I am finding a lot of mixed advice, some of it saying I treat the shares as income and tax according as income during the pay period they make their election.

      Thanks!

  9. I have an s corp ad my company receives a lot of restricted shares as payment for services from start up and early stage public companies. Can an S Corp file the 83 B Election?

  10. Thanks for the simple overview. I have question from a company perspective – if a founder paid the company for his restricted shares that used the 83b election and he left the company prior to his shares fully vesting, does the company owe him the difference in what was paid vs. what was vested?

    2nd question – what is the minimum amount of vesting time required to qualify for 83b election?

    Thanks again!

  11. Do you need a formal valuation of company stock at the time of the stock grant? And, if so, since the total grant is normally of what amounts to a minority interest in the company (even if all the years vest), does that total minority interest get valued at a discount from FMV using the typical discounts for lack of control and lack of marketability?

  12. Hi, thanks for taking the time to explain this. I signed a vesting agreement about 10 months ago, and stupidly forgot to file an 83b within the time limit. The value of the shares of my company have not changed at all in this time– is it possible to work around the 30 day time limit in that case? Or is the only workaround transferring all the shares back to the company, and having them reissue me an equity grant that would be equivalent in terms of how many shares I should currently have, and then file the 83b on that?

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