83(b) Election

The 83(b) election is a provision in the internal revenue code (IRC) that permits the taxpayer to pay taxes based on the market value of restricted stock that they have received at the time of granting, rather than at the time of vesting. The taxpayer can make the election up to 30 days after having been granted the stock via a filing with the IRS. The elector must also notify their company of the election. The technique is commonly used by executives who receive restricted stock as part of their compensation.

The 83(b) election notifies the IRS that the elector has opted to report the difference between the amount paid for the stock and the fair market value of the stock as taxable income. For executives the basis is usually zero. In other words, the stock has been received by the executive outright without consideration so the ‘difference’ will be the FMV x No. of shares. In other words, the difference is the fair market value of the shares at the time of granting.

The decision to use the election requires the elector’s belief that the equity will be worth more in the future than it is at the time of granting, thus electing to pay tax on the equity at its PV, rather than its FV at each vesting date (as commonly shares will vest over a period of years). Suffice to say, if the value of the stock declines in the future, she would have been better off having not made the 83(b) election. In this situation, paying income tax on the value at vesting would have been optimal from a tax expense perspective.

It is important to note that the 83(b) election does not relieve the elector of the standard obligation to pay capital gains tax upon disposal of their equity. Whether or not this will be treated as STCG or LTCG will depend, as usual, upon the holding period.

Mrs. Client has just started working as the Chief Operating Officer for ABC Holdings, a multinational software vendor. A large part of her employee compensation comes in the form of employee stock. Upon joining the company she receives 200,000 restricted stock units. The vesting period is 5 years, with an annual vest of 40,000 shares. The FMV at the time of granting is 3.20 USD per share.

Mrs. Client believes that the company is well positioned in the market to become a market leader and thinks that the company stock is seriously undervalued, with an increase in its stock price being highly probably. Mrs. Client elects to pay tax on her granted stock using the 83(b) election. Her basis in the stock is zero and she pays income tax on the total FMV of the stock at the date of granting.

Mrs. Client files taxes jointly with her husband, Mr. Client, who is also a highly remunerated C-level executive at a public company. Their annual income exceeds the AMT exemption phaseout and as such, Mrs. Client’s effective tax rate on her stock grant equates to the AMTI higher rate of 28%. Based on her election she pays:

200,000 shares X 3.20 USD per share X 28% AMT = 179,200 USD

In the four following years the stock price increases incrementally.

Year 1 – 3.20 USD
Year 2 – 3.80 USD
Year 3 – 4,48 USD
Year 4 – 9.01 USD
Year 5 – 14.77 USD

In the absence of the 83(b) election, and working under the assumption that Mr. and Mrs. Client would continue to be AMT payers, Mrs. Client’s tax payments upon vesting would total:

Year 1 – 3.20 USD x 40,000 shares x 28% = 35,840 USD
Year 2 – 3.80 USD x 40,000 shares x 28% = 42,560 USD
Year 3 – 4,48 USD x 40,000 shares x 28% = 50,176 USD
Year 4 – 9.01 USD x 40,000 shares x 28% = 100,912 USD
Year 5 – 14.77 USD x 40,000 shares x 28% = 165,428 USD

TOTAL = 394,912 USD