Employer Stock – To 83(b) or Not To 83(b)

By Michael Schneider on February 28, 2022

Following up on our initial post on Workplace Equity Compensation, we wanted to discuss tax planning around receiving equity that has a vesting component. When you receive vested equity, you have 30 days to file what is known as an 83(b) Election with the IRS. This election will let the IRS know whether you are going to pay income taxes on the value of all shares received or granted immediately, or as shares are realized over the vesting period. Today, we’re going to look at what you should consider before deciding on the election as well as a couple examples to illustrate the nuances.

What does the 83(b) Election do?

If you make the 83(b) Election, you are deciding to pay ordinary income tax on the value of all shares granted upfront, regardless of the vesting schedule. If you do not make this election, you will pay ordinary income tax on the value of the shares received over the course of the vesting schedule. In both cases, your capital gains tax will be the amount of realized capital gains less the income you have already paid taxes on. Essentially, this election is an arbitrage play on your marginal ordinary income tax rate and the capital gains tax rate.

What should I consider when deciding on the 83(b) election?

A general thought around this election is to determine if you think the company stock is going to take off in a significant way. If you think your company is going to grow, but maybe not at a very fast pace, then maybe it makes sense to hold off on front-loading the tax payment. However, if you are at a start-up enterprise or private company where there is tremendous potential for appreciation, then making the election makes more sense. The greater the appreciation of the stock, the larger the opportunity to arbitrage the difference between the capital gains tax rate and your marginal tax rate.

Also, please consider your current cash flow needs. If the tax bill from making the election is a number large enough to disrupt your overall budget or expense expectations, it may make sense to not make the election. We encourage everyone to have a financial plan and if the large tax bill will put you into a precarious financial situation, the savings on the tax arbitrage may not be worth the headache of a cash flow crunch today.

Examples for Guidance

The first example is a Start-Up Co-Founder with a lot of shares but not a lot of monetary value. The second example is an employee at a publicly-traded company who received fewer shares but at a higher current value.

Example 1: Start-Up Co-Founder

As you can see, by making the 83(b) election and growing a successful company, this founder was able to benefit from paying the income taxes on the very low value of the shares when they were granted and then capital gains on the rest of the value at the time of a sale. Had the founder not made the election, a larger portion of the gain would be subject to ordinary income taxes at each of the vesting periods and the tax bill would be significantly higher upon the sale of the shares.

Example 2: Employee at an established company

While this person still can save money by making the 83(b) election, it is a small amount relative to the total amount of taxes paid upfront. Had this employee not made the election and saved the tax money, the funds could have been invested and generated a larger return on the difference.

Is there a downside to making the 83(b) Election?

There are two potential downsides to making the 83(b) Election and unfortunately, both are difficult to solve at the point in time when you need to make the election. One downside of making the election is if the stock price falls or the company goes bankrupt. In these cases, making the 83(b) Election and paying the taxes upfront would cause you to pay more in taxes than you would have had you not made the election. Another potential downside is if you leave the company before the vesting period is up, you lose out as your paying taxes on shares you never actually took ownership of. In either case, the IRS does not offer leniency and will not refund your overpayment – a financial and emotional double whammy.

At the end of the day…

The 83(b) Election can be very lucrative if you are at a young company where the equity you receive has a lot of potential for growth. If you are at a larger, maybe already public company, the potential appreciation is most likely not going to be the same. When making this decision for yourself, always run the numbers by your accountant or a tax professional. If you have any questions regarding your own equity compensation, please feel free to reach out to mschneider@hightoweradvisors.com