Knowing the tax law and its different provisions is one approach to preventing paying too much in taxes. 83(b) election tax strategy to assist you in reducing the tax burden for employees or firms. Suppose you are a startup founder or employee and you get restricted stock awards (RSA) or options as part of your payment. You may get significant tax savings by making an Internal Revenue Code (IRC) Section 83(b) election. This article gives you an insight into, who can make an 83(b) election, the benefits of filing 83(b) election, 83(b) election tax treatment, along with an 83(b) election example.
83(b) election tax strategy
Startup founders or employees can pay their taxes on the fair market value of restricted shares at the issuance date under the IRC’s 83(b) option. 83(b) election covers only the vested stock. Employees and company owners may save much on income tax using the 83(b) election tax strategy.
What is 83(b) election?
According to the Internal Revenue Code’s (IRC) 83(b) election clause, an employee or business founder can settle taxes at the time of issue. By filing an 83(b) election, you can settle income taxes before the price of your company’s shares has a chance to rise. You’ll only be liable for taxes on capital gains when you sell shares for a profit.
What is 83(b) election tax strategy and how does it work?
The 83(b) election enables co-founders to pay taxes on equity before the vesting period starts. This tax plan helps co-founders minimize tax liability by considering their shares’ fair market value minus stock option costs. No taxable gain occurs when an asset’s fair market value matches its strike price.
The 83(b) election informs the IRS that the elector has chosen to report the difference in the price paid for the stock and the stock’s fair market value. The co-founder will not be subject to any additional taxation and able to keep the vested shares during the vesting period of 5 years. Capital gains tax is applicable only if shares are selling at a profit.
The 83(b) election is helpful when the elector is confident that the value of the shares will rise in the years to come. An 83(b) election could be helpful if the income reported at the time of the grant is low.
For example, If the stock is sold after 5 years for $150,000, The capital gain tax would apply to $149,500 ($150,000 minus $500).
In contrast, If the equity value drops or the company declares bankruptcy after the 83(b) election the taxpayer has overpaid in taxes for shares worth a lower amount. Unfortunately, The Internal Revenue Service will not accept a claim for a tax overpayment made using the 83(b) election. Take the case of an employee whose 83(b) election results in an immediate tax liability of $20,000, since the value of the vested stock drops over a four-year vesting period. Here the individual would have been better off not making the 83(b) election and instead paying tax each year on the reduced value of the vested equity.
Benefits of filing 83(b) election
- Tax benefit: Paying taxes on the stock’s current value upfront can result in lower tax payments if the stock increases in value.
- Early Taxation: By choosing to pay taxes on the grant date, you can reduce your tax liability on potential future gains.
- Confirmation of Ownership: Defining ownership and avoiding tax surprises upon stock vesting.
- Potential for Lower Rates: Taxes on capital gains may be more beneficial than those on ordinary income.
- Risk management: By establishing an early tax baseline, you can protect yourself from changes in stock value.
- Reporting Simplified: Simplify tax reporting by taking care of any potential tax problems upfront.
83(b) election tax treatment
You send a letter to the IRS asking to impose tax on restricted stock or other equity when granted, not when vested. Let’s illustrate this with an example.
Example of 83(b) election tax strategy
Assume that you receive 100,000 shares of restricted stock. You have a four-year vesting schedule, with 25% of the award becoming yours each year. You begin to vest 25,000 shares the first year after the grant date, and you continue to vest 25,000 shares for the next three years, reaching full vesting in year four. Once the shares have vested each year, you choose to sell them. You pay a 3.8% net investment income tax on top of your marginal tax rate of 37%. As the stock grants, it is worth $1 per share, and when it vests, its value rises by $1 yearly.
In the first case, you exercise your 83(b) right within 30 days of receiving the award. At the time of vesting, you intend to sell the shares to avoid generating capital gains.
In this case, you decide against making an 83(b) and pay ordinary income tax when shares vest each year instead. At the time of vesting, you are to sell the shares immediately to avoid generating capital gains.
By contrasting these two examples, you can see that choosing to make an 83(b) election would result in significant long-term tax savings for this person.
Who can file 83(b) election?
- Stock option holders: If you can exercise your stock options before they vest, you may submit an 83(b) election within 30 days. This reduces your prospective tax burden if your company’s stock price increases.
- Startup founders: In businesses like startups, founders or owners contain a portion of restricted shares. Key personnel will get a large number of restricted shares, the value of which may rise sharply between issuance and vesting. These workers can save money by switching their tax status from regular income taxes to capital gains taxes by making the 83(b) option.
When and how to file 83(b) election?
You must submit your 83(b) election within 30 days of receiving restricted shares or within 30 days of the early. If you don’t, your business shares will be taxed as ordinary income when they vest.
The process of filing 83(b) election is simple, as outlined below –
The employee finishes and submits an IRS Form 83(b) letter or form that contains the following essential information –
- Information identifying a person (name, Social Security number, address).
- In addition to the date received or acquired, the description of the asset granted (the number and kind of shares of whatever business), any limitations to shares and fair market value should be included.
- The sum paid for the shares of the corporation.
- Include the sum as gross income on your tax return.
The employee sends a copy of the 83(b) election letter or form to their employer and mails the original to their IRS Service Center. It’s best to send your election using certified mail, with a return receipt, in case you need to show that it will be delivered by a certain date.
A knowledgeable tax or financial adviser may assist you in determining whether to proceed if you’re unsure that 83(b) matches your requirements.
Get experts’ help filing 83(b) election with Eqvista!
Consider every aspect before submitting your 83(b) election application. The impact choice on your income tax and capital gains tax, as well as the potential future value of the firm. If you believe the company will expand, you can go for 83(b) election. To know more, contact us today.