Have you ever been in the grocery store check out line, reached into your pocket, and pulled out a coupon only to find that it had already expired? You may experience a similar feeling (magnified, perhaps, by the amount of money involved) if you are issued equity subject to vesting in a company and you don’t hear about tax code Section 83(b) until after 30 days have gone by, the de facto expiration date for filing the Section 83(b) election we’re about to discuss.
So what is a Section 83(b) election? It’s a letter you send to the Internal Revenue Service letting them know you’d like to be taxed on your equity, such as shares of restricted stock, on the date the equity was granted to you rather than on the date the equity vests. It’s important to note here that Section 83(b) elections are applicable only for stock that is subject to vesting, since grants of fully vested stock will be taxed at the time of the grant. Put simply, it accelerates your ordinary income tax.
A Little Background on Taxes
To provide some simple tax background, there are different types of tax rates. The maximum ordinary income tax rate in 2014 is 39.6%, whereas the maximum long-term capital gains rate in 2014 is 20%. Because the United States uses graduated tax rates (meaning the rates vary based on your income), you may actually be subject to lower rates, but in each case the long-term capital gains rate will be lower than the ordinary income tax rate.
Assuming you paid nothing for your restricted stock, you will be taxed on the value of your restricted stock as determined at grant (if a Section 83(b) election is filed), or at vesting (if no Section 83(b) election is filed), in each case at the applicable ordinary income tax rate. When you later sell your stock, assuming it’s been more than one year from the date of grant (if a Section 83(b) election is filed), or more than one year from the date of vesting (if no Section 83(b) election is filed), the additional gain will be taxed at the applicable long-term capital gains rate. Because the long-term capital gains rate will be lower, the goal here is to get as much of your gain as possible taxed using that rate, rather than the ordinary income tax rate.
Two Simple Examples
In each of the below examples, assume you receive 100,000 shares subject to vesting, worth $.01 per share at the time of grant, $1.00 per share at the time of vesting, and $5.00 per share when sold more than one year later. We’ll also assume you are subject to the maximum ordinary income tax rate and long-term capital gains rate. For simplicity, we will not discuss the employment tax or state tax consequences.
Example 1 – 83(b) Election: In this example you timely file a Section 83(b) election within 30 days of the restricted stock grant, when your shares are worth $1,000. You pay ordinary income tax of $396 (i.e., $1,000 x 39.6%). Because you filed a Section 83(b) election, you do not have to pay tax when the stock vests, only on the later sale. On the later sale which occurs more than one year after the date of grant you recognize a taxable gain of $4.99 per share (not $5.00, because you get credit for the $.01 per share you already took into income), and pay additional tax of $99,800 (i.e., $499,000 x 20%). Your economic gain after tax? $399,804 (i.e., $500,000 minus $396 minus $99,800).
Example 2 – No 83(b) Election: In this example you do not file a Section 83(b) election. So you pay no tax at grant (because the shares are unvested), but instead recognize income of $100,000 when the shares vest and thus have ordinary income tax of $39,600. On the later sale which occurs more than one year after the date of vesting you recognize a taxable gain of $4.00 per share (not $5.00, because you get credit for the $1.00 per share you already took into income), and pay additional tax of $80,000 (i.e., $400,000 x 20%). Your economic gain after tax? $380,400 (i.e., $500,000 minus $39,600 minus $80,000).
So in the above example, filing a Section 83(b) election would have saved you $19,404. Filing a Section 83(b) election also has two other benefits. It would have prevented you from having a $39,600 tax hit when the stock vested, which may have been at a time you may not have had cash to pay the tax, and it also starts your long-term capital gains holding period clock earlier – meaning that you get the long-term capital gains rate as long as the sale of your shares occurs more than a year after grant, rather than a year after vesting.
So you ask, if Section 83(b) elections are so beneficial, why doesn’t everyone file one? If you receive restricted stock worth a nominal amount, it virtually always makes sense to file one. However, what if instead of receiving 100,000 shares of restricted stock worth $.01 per share, you received 100,000 shares of restricted stock worth $1.00 per share? Filing a tax code Section 83(b) election would immediately cause you tens of thousands of dollars of tax. And if the company subsequently fails, and in particular if it fails before your stock vests, you likely would have been economically better off to not have filed a Section 83(b) election.
Bottom line – discuss with your individual tax advisor, but remember that the filing must be made (if at all) within 30 days after the grant date of your restricted stock, as that is an absolute deadline that cannot be cured. And note that the grant date of your restricted stock is usually the date the board approves the grant, even if you don’t receive the restricted stock paperwork until later – so sometimes you need to be super efficient about making this decision and filing the correct paperwork.
Steps to Filing a Section 83(b) Election
- Send the original election form and cover letter to the Internal Revenue Service Center where you would otherwise file your tax return within 30 days after the date of grant.
- For this purpose the date your letter is postmarked is considered the date filed.
- Ask your tax advisor for the correct Internal Revenue Service Center address or you can also find it by searching for the term “where to file” on www.irs.gov or by calling 1 (800) 829-1040.
- Sending the election via certified mail, requesting a return receipt, is also recommended.
- Deliver one copy of the completed election form to the company issuing the stock to you for whom you are providing services.
- Attach one copy of the completed election form to your federal personal income tax return (Form 1040) for the calendar year in which you received the stock, when you file it the subsequent year.
- Attach one copy of the completed election form to your state personal income tax return for the calendar year in which you received the stock, when you file it the subsequent year (assuming you file a state income tax return).
- Retain one copy of the completed election form for your personal permanent records and retain proof of mailing.
- And if you are the service provider, but not the recipient of the stock (because for example, it is being issued into a trust on your behalf), a copy of the completed election must also be provided to the recipient.