Tax planning is an important aspect of an overall financial plan and can add a lot of value. One such opportunity to add value to your bottom-line is by filing for a section 83(b) election for early taxation of restricted stocks or stock options awarded to you.
What is an 83(b) election?
An 83(b) election allows the holder of restricted stocks to pay taxes on the award before it vests. For holders of unvested stock options, it provides an opportunity for early exercise of the options and pay any taxes due. Without filing an 83(b) election, taxes would only be due after your restricted stocks vest or when you exercise your vested stock options.
How does filing an 83(b) benefit you?
The benefit of this election is that if the stock price appreciates over time after the grant and you hold the stock for more than a year, you will pay the lower long-term capital gains tax rate instead of the higher ordinary income tax rate on the appreciation of the stock. Consider the following two examples:
Example 1 for restricted stock grant.
Assume you were granted 10,000 restricted stocks valued at $2 each on 1/1/2018 and assume they vest on 1/1/2020 when the stock has appreciated to $5. If you do not file an 83(b) you will pay no taxes on the date of the grant. On the vesting date, you would receive 10,000 shares and pay ordinary income taxes on 5*10,000 or $50,000 in income. If you then hold the stock for more than one year before selling, you will pay long term capital gains taxes on the appreciation in the value of the stocks between the vesting date and the date of sale.
On the other hand, if you file an 83(b) (You have 30 days to file from the date of grant) you will pay ordinary taxes on the date of grant on $20,000 in income i.e. 2*10,000. No taxes are due on the vesting date. On the date of sale, you pay the favorable long-term capital gains taxes on the appreciation. As compared to the case where 83(b) was not filed, you pay no taxes on the date of grant and you end up paying the lower long term capital gains tax on $30,000 of appreciation in the value of the stocks between the grant date and vest date and you only have to pay that tax when you sell the stocks.
Example 2 for stock options
Assume you were granted 10,000 stock options with a strike price of $1 on 1/1/2018 and they vest on 01/01/2010 when the stock has appreciated to $2. If you do not file an 83(b) you will pay nothing for the options or in taxes on the date of grant. After the options vest and if you exercise your options at that time, you will pay $10,000 i.e. $1*10,000 for exercising the options and ordinary income taxes on the value of the options over the strike price i.e. (2-1) *10,000 i.e. $10,000. If you then hold on to the stock for more than a year, you will pay long term capital gains on any appreciation between the date of exercise (also the date of vesting in this example) and the date of sale.
On the other hand, if you exercise your options early and file an 83(b) (You have 30 days from the date of exercise to file and for this example assume you exercise when the options are granted), then you will pay $10,000 i.e. 1*10,000 to your company to exercise the options. No taxes are incurred at this time, since the stock has not appreciated over the strike price and you don’t have any gain. Assuming that you sell on the date of vesting you will pay the favorable long term capital gains taxes on $10,000 of appreciation i.e. (2-1) *10,000 instead of ordinary income taxes as in the case where the 83(b) was not filed.
As seen in the above examples, filing an 83(b) can reduce taxes by ‘converting’ ordinary income into long term capital gains. However, despite what some advisors will tell you, the decision to file is not that straightforward and depends on several factors some of which are discussed below
If you leave the company or the company fails before your award vests: In the case of restricted stocks, in most cases, if you leave your company before your grant vests, you will lose the restricted stocks and the money you
paid in taxes. Similarly, if your company goes bankrupt before your award vests, your restricted stocks and
stock options become worthless and you lose the money you paid in taxes or to purchase the underlying stocks.
Your risk tolerance must be considered when making the decision because early exercise increases the
percentage of your net worth tied to your company stock. Any evaluation must be made on an after-tax basis
which requires you to forecast future tax rates.
Stock concentration plays a role especially if you already have a substantial amount of company stock in which
case you may not want to increase the stock concentration by early exercise.
Stock price appreciation must be considered. Clearly, the benefit of filing 83(b) increases the more the stock
appreciates after the grant date/exercise date. If stock price declines instead, filing could turn out to be
disadvantageous.
Amount of money at risk: Since filing an 83(b) is not without risk as per the points above, the amount of money
in taxes and to purchase the stock must be considered in making the decision. In early stage companies, the
strike price of the options granted tends to be very low making the filing advantageous especially if the stock is
expected to appreciate significantly.
Future tax rates: If tax rates are expected to increase in the future, early exercise can be beneficial.
Individual company policies play a role when it comes to deciding whether filing an 83(b) is advantageous or
not because each company has its own policy on what is allowed and what is not.
Like most tax planning situations managing restricted stock awards and stock options requires an analysis of your
overall situation for optimal decisions. Decisions taken in isolation could lead to lost opportunity cost or losses.