Tax recognition of gains on restricted shares (83B elections)
Keep reading to know more about 83(b) elections.
Today with equity-based compensation becoming more and more common in companies, Section 83(b) is a frequent discussion topic among employees and taxes. It will determine how much tax they owe on their shares of the company. But what exactly is the 83(b) election, and how can it benefit you?
While this rule may not be the most exciting regulations for business owners and employees, at the end of the day, it could end of saving you thousands of dollars.
Still confused what the Section 83(b) is? Well, this article would explain all about it. Furthermore, if you are an employer, it is also important for you to know all the tax details for restricted stocks. This would help guide your employees for their tax responsibilities, after awarding them restricted shares as employee compensation. Keep reading to know more about 83(b) elections.
What are 83B elections?
The 83(b) election is a provision that falls under the IRC (Internal Revenue Code). As per this provision, a startup founder or an employee gets the option to pay taxes on the FMV (fair market value) of the restricted shares when the option is granted. This is applied only to equity that is subject to vesting. It also gives an alert to the IRS for taxing the elector of their ownership at the time the option was granted, instead of when the option is vested.
This basically means that with the 83(b) election, you would be able to pre-pay the tax liabilities at a much lower valuation (FMV for the restricted shares). It is possible that the valuation at the time of the grant would be less than at the end of the vesting period. Also with the 83(b) election, you would not have to pay tax on a higher amount from an increase in valuation later on. Nonetheless, in case the company’s value drops, this strategy for paying taxes would eventually mean that you overpaid for the restricted shares.
Normally, when an employee or a founder gets restricted shares as compensation of the company, the shares are then subject to income taxes based on its value.
The taxes due has to be paid during the year in which the stock was transferred or issued. However, there are cases where the person gets the equity vested over multiple years. This allows the company’s employees to earn shares when they are employed in the company over the specific period.
In such a case, the tax on the equity value has to be paid before or on the vesting date. If the value of the company grows during the vesting period, the overall tax paid each year over the vesting period would increase accordingly.
Let us take an example to illustrate this. Imagine a co-founder is given 1 million restricted shares of the company, subjected to vesting, and each are valued at $0.01 per share. At that moment, the shares are worth $0.01 each, times the number of shares (1 million shares) = $10,000. This is the amount that the co-founder pays.
These shares represent about 10% of the ownership of the firm for the co-founder, and it has a vesting period of five years. This means that the person would get about 200,000 shares each year over the vesting period. The co-founder has to pay the FMV for the 200,000 shares that is vested annually, over the five years.
If the overall equity value of the corporation raises to about $1,000,000, then the 10% value of the co-founder’s share increases in the company from $10,000 to $100,000. This means that his tax liability for the first year would be deducted from ($100,000 – $10,000) x 20%, which in effect, ($1,000,000 – $100,000) x 10% x 20% = $18,000.
- $1,000,000 is the first year value of the corporation.
- $100,000 is the value of the company at the inception or the book value.
- 10% is the co-founder’s ownership in shares of the company.
- 20% represents the co-founder’s 5-year vesting period for the 1 million shares that the co-founder got (200,000 shares/1 million shares).
If in the second year, the value of the stock raises to about $300,000, the co-founder would have to pay taxes on ($300,000 – $100,000) x 10% x 20% = $4000. And until we reach year 3, the value of the company reaches $10,000,000. This means that the tax liability of the co-founder here, would be assessed from ($10 million – $100,000) x 10% x 20% = $198,000. It is obvious that if the value of the company keeps increasing in the next two years as well, the additional taxable income would also increase for the co-founder for each of the years.
Moreover, in case in the future, if all the shares of the co-founder are sold for a profit, it would be subjected to the capital gains tax on the profits from the proceeds of the sale.
What are the benefits of an 83(b) election?
There are multiple benefits of filing the 83(b) election. As mentioned above, the section 83(b) is a part of the IRC which permits founders or employees to pay their respective taxable income on the purchase or award of the restricted shares on the date it is granted instead of on the date the shares are vested. In case the restricted shares are bought for the same price equal to the FMV, then the section 83(b) election would result in no recognition of the income on the date of the purchase.
In addition to this, the section 83(b) election includes the commencement of the 1-year long-term capital gain holding period, that usually results in advantageous capital gains instead of the ordinary tax treatment as soon as the restricted shares are sold (the long-term capital gain tax rates are 0, 15 & 20 percent for most taxpayers).
Filings 83B election vs Non-filing of 83B
If a person files the section 83(b) election, the person would be able to avoid paying any extra tax that they would have to pay later on due to an increase in the restricted share value. As explained in the example above, with the increase in the stock prices with the company’s value, the tax placed on the shares purchased increases. And if the person pays in the year they purchase the shares (even if they are not vested), and files for the section 83(b) election as soon as the shares are bought, they would not have to pay higher tax rates when the shares are vested.
But what happens in case the founder does not file the election before the deadline or if the person does not file the section 83(b) election at all? In such a case, they would have to pay taxes on the grants on the vesting date.
Further, the tax would be assessed at the standard income rates on the total amount of the restricted shares on the vesting date. And if the company’s value raised leading to the substantial increase in the price of the restricted shares over time as compared to the date the shares were granted, this would lead to a significant tax obligation.
What are the risks of an 83(b) election?
Even though there are a lot of benefits of the 83(b) election, it also has some added risks to it. With the filing of the section 83(b) election, the date on which the taxable income is recognized is accelerated from the vesting date to the date when the restricted shares are purchased or granted.
This basically means that in case the founder or employees file the section 83(b) election, they would then pay all the taxes on the income that would be based on the FMV of the shares on the date of the grant. But later on, in case the person forfeits their shares, they would have to pay taxes on their unrealized income.
To understand it better, let us have a look at the various scenarios that would make the section 83(b) election more or less advantageous for any founder or employee. With all the things considered, here are the following scenarios:
Scenario #1: The section 83(b) election is more advantageous when:
- The risk of the restricted shares forfeiture is extremely low.
- The growth prospects of the restricted shares are moderate to strong.
- The overall income amount that is reported at the grant date is small.
Scenario #2: The section 83(b) election is less advantageous when:
- The risk of the restricted shares forfeiture is moderate to high.
- The growth prospects of the restricted shares are low to moderate.
- The overall income amount that is reported at the grant is large.
Effect of this on taxes
The section 83(b) elections offers the co-founders or employees with the option to pay all the taxes on the restricted shares that they purchased or were granted upfront before the vesting period begins. With the example above, where a founder gets about 1 million shares with an initial cost of a $0.01 per share, this means that he paid $10,000 for the 1 million restricted shares from the company’s shares.
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Now, if he elects the section 83(b) tax strategy, he would only have to pay the taxes on the book value of $10,000, regardless of the rise in the company’s value. With the filling of the section 83(b) election, the IRS would be notified that the elector has chosen to report the difference between the fair market value of the restricted shares and the amount paid for it as taxable income.
The section 83(b) election should be opted for and makes the most sense only when the person is sure that the overall value of the shares would increase in the coming years. Moreover, in case the income amount is reported as small during the grant time, the 83(b) election would be highly beneficial.
However, in a scenario where the section 83(b) election was triggered, and the company files for bankruptcy or the value of the company shares falls, then the taxpayer has overpaid the taxes for the restricted shares. Unfortunately, the IRS doesn’t permit any claim for the overpayment of taxes under the section 83(b) election. Therefore, this may be a drawback when considering the section 83(b) election.
Let us understand better with two different examples.
In each example, let us say that you are a founder and you get about 100,000 shares from the company’s stock, subject to vesting. The restricted shares that you get are priced at $0.1 per share at the grant date, while the amount is $2 per share at the time of vesting. Furthermore, the shares are $10 per share when sold a year later.
In each example, we would assume that you are subject to the long-term capital gains rate and the maximum ordinary income tax rate. To make it simple, we disclude any employment or state income taxes.
Example 1 – 83(b) Election
Let us say that you file the section 83(b) election within a 30-day period as soon as you were granted the restricted shares, with a value of $10,000. For this, you pay the standard income tax of $3,960 (that is, $10,000 x 39.6%). As you have filed for the section 83(b) election, you would have to pay any tax on the restricted shares now when vested. You would only need to pay when you sell it to someone else later on.
When you are selling the shares after one year from the grant date, you would have to pay the taxable capital gains on the amount $9.9 per share (and not $10 since you get the credit for the $0.1 per share that you had already taken into your income). You would have to pay an additional tax of about $198,000 (that is, $990,000 x 20%). The economic gains after tax would be $798,040 (that is, $1,000,000 – $3960 – $198,000).
Example 2 – No 83(b) Election
If you choose not to file the section 83(b) election, you do not pay any tax during the grant period as the shares are not vested yet. But in this case, you receive an income of $200,000 (at $2 per share) as soon as the shares are vested and thus, you have an ordinary income tax of $79,200.
When you sell the shares later on after a year from when the shares were vested, you get a profit on the sale with a taxable gain of about $8 per share (and not $10 since you get the credit for the $2 per share that you have already taken in as income). You would have to pay an additional tax of about $160,000 (that is, $800,000 x 20%). The economic gains after tax would be $760,800 (that is, $1,000,000 – $79,200 – $160,000).
So, in the second example, if you had filed the filing a Section 83(b) election would have saved you $37,240. But that is not all. There are two other benefits for filing the section 83(b) election.
You would have been saved from having a direct tax hit at one time of about $79,200 as soon as the restricted shares are sold. This also begins the long-term capital gains holding period clock earlier when the shares are granted, rather than when they are fully vested. This means that you would be able to start earlier for long-term capital gains and a lower tax rate for the sales of the shares.
Another thing to note is that the grant date is normally the day when the board approves the grant and not when you get it. Hence, at times, you would have to be on top of taking the right decisions and filing the paperwork.
Steps how to file the 83B election
The section 83(b) election is a form that has to be filed and the documents sent to the IRS within a 30-day period from the date the restricted shares have been granted. Other than the need to notify the IRS about the election, the person would also have to submit a copy of the section 83(b) election form to their employers, with a copy of their annual tax return.
For being able to make the section 83(b) election, a few steps have to be followed within a 30-day period from the grant date. Here are the steps:
- Get the section 83(b) election form and fill it. You can get the form from a government agency or from the IRS website online.
- As soon as the form has been filled, keep three copies with you along with the original one.
- Send the original letter to the IRS within a period of 30-days from the grant date. Here are two points that needs to be kept in mind:
- Send the original and completed form of election along with the cover letter, a self-addressed stamped return envelope, and a copy of the cover letter to the IRS Service Center, which is the same place where the tax returns are filed. And even though you have the address mentioned in the form that you are filling, it is better to verify the address by checking it on the their website. Visit the IRS website to find out the exact address.
- It is advised to mail the letter and form to an IRS address via certified mail. Additionally, it is also important to ask the mail for the receipt and keep it with you in case you need to show it to the IRS due to any mishaps.
- Give one of the completed election form to the company in which you are working or in the one you are a founder of. As per the applicable state law, you might have to add a copy of the form along with the personal income tax returns when filing it.
- Do not forget to keep a copy of the section 83(b) election form, a copy of the cover letter and the receipt for mailing it to the IRS with you in your records.
Other than the points mentioned above, it is vital that the filers/electors should consult with tax advisors or lawyers before they can determine if they need to file the section 83(b) election for the restricted shares they got or not.
It is vital to keep note that the section 83(b) election needs to be filed with the IRS within a 30-day period from the date when the restricted shares are granted. In case anyone fails to file the election letter on time, this will render the election void for the person. They would then have to pay taxes on the shares, based on the ordinary taxable income rates as the vesting restrictions lapse.
Now that you are aware of all the taxes that are applied to the gains on the restricted shares and how you have to report them, you can be sure to have your taxes paid on time without any trouble. It is important to have all the information and use them in the right way so that you do not have to pay heavy penalties in the end.
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