What is an 83b election?
How do you know if you should make one? And how do you do it?
(This is not legal or tax advice.)
If you are given stock, or any other kind of equity in a company, in exchange for your work, that equity is payment for your service. It will be taxed as compensation.
This is why sweat equity can lead to tax problems. If someone is paid in the form of stock but not cash, the value of that stock will be taxed as their compensation. (That is, the value minus the purchase price, if any. If the purchase price is $0, then the value of the stock is taxable compensation.) The person will have to pay tax in cash out of pocket, whether they received cash from their company or not.
Many companies use equity compensation that is subject to vesting, and this is where 83b comes in. An 83b election works only for equity that is subject to vesting (or some other condition that could cause forfeiture of the equity). If you make an 83b election, you are choosing to pay tax now rather than when it vests. Without 83b, there is no tax liability when you receive the stock that's subject to vesting (because it might be forfeited). When the stock vests, you would be taxed on the fair market value of the stock minus what you paid for it. With an 83b election, you pay tax on the fair market value of the stock when you received it (minus what you paid for it), and then there is no additional tax liability when it vests. (I am using restricted stock as an example, but it could be other equity.)
Let's use an example to see how this works.
Imagine you receive 100 shares of restricted stock subject to vesting, when the stock is worth a penny per share. You pay $0 for this stock. Then, you work at the company for 4 years, the stock vests, and after 4 years, the fair market value is $100/share. Without 83b, at this point, you have taxable income of $10,000. You will have to pay tax in cash, even though you didn't receive any cash from that stock yet.
Next, imagine you receive 100 shares of restricted stock subject to vesting, when the stock is worth a penny per share. You pay $0 for this stock. You make a timely 83b election. Your taxable income from this stock grant will be $1 this year, so you report that $1 on your tax return. Then, you work at the company for 4 years, the stock vests, and after 4 years, the fair market value is $100/share. Now you have stock worth $10,000 that you received as compensation, but you paid tax on $1 in income rather than $10,000.
Think about your equity compensation, and think about what it will be worth when it vests. Think about what it is worth on the date of the award. Think about the tax liability on the first amount versus the tax liability on the second amount. That is the reason people choose to make an 83b election. If you believe you might need professional advice, ask your accountant or financial advisor.
As you can see, for founders of brand new companies, it generally makes sense to issue yourself shares at a nominal value. If your stock is restricted stock that is subject to vesting or a repurchase option, that you receive at a nominal value, and you expect that value to increase, it's generally an advantage to make an 83b election.
An 83b election also makes the gain into a capital gain rather than compensation income.
In the first example, without the 83b election, your taxable income was $10,000. That is also the basis of that stock, so let's imagine that later you sell the 100 shares for $1,000/share. The net income from that sale will be $100,000 minus $10,000 = $90,000. That income will be subject to capital gains tax.
With the 83b election, your taxable income was $1, also the basis. This time, the income from the sale will be $100,000 minus $1 = $99,999. Subject to capital gains tax.
So as you can see from this example, when you make an 83b election, you are trading reduced tax on compensation in the short term for higher capital gains tax later.
How to make an 83b election:
When to file: no later than 30 days after receiving the stock or other equity.
What to send:
-mail a copy of a written statement to the IRS office where you file your tax return.
-submit a copy of the statement with your tax return for the taxable year in which the equity was received.
-submit a copy of the written statement to the company whose equity it is.
There is no 83b election form provided by the IRS. It is just a letter, there is no official format, but it needs to include specific information. (Here is a template.) If you want to make an 83b election for yourself, your statement must include:
-your taxpayer ID
-a description of the property with respect to which the election is being made,
-The date or dates on which you received the property,
-The taxable year for which the election is being made,
-The nature of the restriction or restrictions to which the property is subject,
-The fair market value at the time of transfer determined without regard to any lapse restrictions
-the amount you paid for the property
-a statement to the effect that copies have been furnished to the company as required
- you must sign the statement.
For more detail, see: Revenue Procedure 2012-29, irs.gov/pub/irs-drop/rp-12-29.pdf