Why the 83(b) Election is a Game-Changer for Startups

Navigating the world of startups and early-stage companies can be exhilarating, yet the complexities of the U.S. tax code can often feel like a maze. One incredibly powerful provision at your disposal is the 83(b) election. Let’s break down what exactly the election is and why should you care about it.

What is the 83(b) Election?

The 83(b) election is a provision of the Internal Revenue Code (IRC). It allows those who receive restricted stock or other property subject to vesting to elect to include the fair market value of the property at the time of grant in their taxable income upfront. At first glance, this might seem counterintuitive. Why would you want to pay taxes on something now rather than later? The answer lies in the potential tax benefits.

The Default Tax Scenario

Restricted stock or property as part of a compensation package becomes taxable as income when it fully vests. Therefore, if the stock increases at all in value, which is the hope, your tax will increase alongside it.

The 83(b) Election Scenario

By making an 83(b) election, you opt to recognize the fair market value of the property as income at the time of grant. Your stock does not have to be fully vested to make the election. Essentially, you’re paying taxes on the current (and often lower) value of the stock. If your company grows and the stock’s value climbs, you’ll only pay taxes on that initial, lower value. It is important to note however that the future appreciation is typically taxed at the capital gains rate. This rate is typically lower than the ordinary income tax rate.

Why is the 83(b) Election Significant?

Tax Savings Galore

The primary advantage is the potential for significant tax savings. Imagine you receive stock worth $1,000 today, but in five years, that stock is worth $100,000. If you didn’t make the 83(b) election, you’d be taxed on that $100,000 value as it vests. But if you did make it you’d only be taxed on the $1,000 value now. The appreciation to $100,000 would be taxed at the lower capital gains rate when you sell.

Ideal for Early-Stage Startups

For employees or founders of early-stage startups, the 83(b) election can be particularly beneficial. At the time of grant, the stock’s value is often quite low because the company is still in its infancy. Electing to be taxed on this low value upfront can lead to substantial savings if the company becomes successful and the stock value soars.

The Risks Involved

While the 83(b) election offers enticing benefits, nothing is without its risks. If the property becomes worthless or the restrictions never lapse, you’ve paid taxes on value you never actually receive. Additionally, once you make the election, it’s irrevocable – you can’t change your mind later.

Making the 83(b) Election

To make an 83(b) election, you must file a written statement with the IRS within 30 days of receiving the property. This statement should include:

• Your name, address, and Social Security number
• A description of the property
• The property’s fair market value at the time of grant
• A statement declaring that you are making the 83(b) election

It’s also wise to send a copy to your employer and keep another for your records.

A great example with instructions on how to file properly by Fidelity.

Conclusion

The 83(b) election is a valuable tool in the tax arsenal for individuals who receive restricted stock or property. Especially in the context of startup employees and founders. By choosing to include the fair market value of restricted stock or property in your taxable income upfront, you can potentially save a bundle on taxes, especially if your company’s value skyrockets. However, it’s essential to weigh the risks and consult with a tax professional to ensure it aligns with your financial situation and long-term goals. With the right strategy, the 83(b) election can be a game-changer in your entrepreneurial journey.

Please reach out to our team with any questions, we are here to help you!