Section 83(b) election: Overview, definition, and example
What is a Section 83(b) election?
A Section 83(b) election is a tax election that allows an individual receiving restricted stock or equity compensation to pay taxes on the value of the shares at the time of grant rather than when they fully vest. This election is filed with the IRS and can be beneficial if the stock’s value is expected to increase, as it allows the recipient to be taxed at a lower initial value.
For example, if an employee receives restricted stock valued at $1 per share, they can file a Section 83(b) election and pay taxes on that value immediately. If the stock later appreciates to $10 per share, they avoid paying taxes on the increased value upon vesting.
Why is a Section 83(b) election important?
A Section 83(b) election is important because it enables individuals to control when they pay taxes on equity compensation, potentially reducing the overall tax burden. By paying taxes early when the stock value is lower, they may benefit from long-term capital gains treatment on future appreciation rather than paying ordinary income tax at vesting.
For businesses, offering employees or founders the ability to make a Section 83(b) election makes equity compensation more attractive, especially in startups or high-growth companies where stock values can increase significantly over time. However, if the election is not filed within 30 days of the grant date, the opportunity is lost.
Understanding a Section 83(b) election through an example
A startup grants a co-founder 100,000 shares of restricted stock at a nominal value of $0.01 per share. The shares will vest over four years, meaning the co-founder would normally be taxed on the value of the shares at vesting. However, the co-founder files a Section 83(b) election and pays taxes immediately on the $1,000 value ($0.01 x 100,000 shares).
Three years later, when the shares vest, they are worth $5 per share ($500,000 total). Because the co-founder made the election, they do not owe income tax on the increase and instead qualify for long-term capital gains tax when they eventually sell the shares.
In contrast, if the co-founder did not file a Section 83(b) election, they would owe ordinary income tax on the $500,000 value at the time of vesting, potentially resulting in a much higher tax liability.
Example of a Section 83(b) election clause
Here’s how a Section 83(b) election clause might appear in a contract:
“The Recipient acknowledges that any unvested Shares granted under this Agreement are subject to taxation at the time they vest unless the Recipient makes a timely Section 83(b) election. The Recipient is solely responsible for filing the Section 83(b) election with the IRS within thirty (30) days of the grant date and assumes all tax consequences associated with such election.”
Conclusion
A Section 83(b) election allows individuals receiving restricted stock or equity compensation to pay taxes upfront at a lower valuation, potentially benefiting from long-term capital gains tax treatment. This election is especially valuable in high-growth companies where stock prices are expected to increase over time. Filing a Section 83(b) election correctly and on time is crucial, making it an essential consideration for anyone receiving equity compensation.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.