If you have been involved with a startup company, you very likely have run into grants of restricted stock and the decision if you should make an 83(b) election. Basically an 83(b) election is a choice you make to assert your rights under section 83(b) of the Internal Revenue Code. Section 83 deals with the transfer of property (usually some form of stock, restricted stock grants or stock options) in exchange for performance of service and when you must recognize taxable income from that exchange. When you are given assets that have restrictions on your ability to sell or trade those assets, you do not have to recognize the income until you have unrestricted rights to exercise your ownership of those assets.
Say you receive stock in a startup that is worth $10K, but you are prohibited from selling that stock for 5 years. That means you don’t have taxable income until those restrictions expire. So not paying tax for 5 years is a good thing, except during the next 5 years your company is expected to go public and that $10K worth of stock is going to be worth $250K in 5 years. By not paying tax on the ordinary income of $10K today you now have to pay tax on ordinary income of $250K, 5 years from now. Specifically subsection b of section 83, allows you to accelerate the recognition of income from receiving your stock. You get to say I want to report the $10K of ordinary income today and pay the tax today, then any future appreciation in the value of the stock becomes a capital gain rather than ordinary income. Capital gains are generally taxed at a lower rate than ordinary income which is why you might want to pay tax now rather than later. You are effectively paying ordinary income tax rates on a much smaller amount of income and in the future pay capital gains tax rates on the increase in value of your stock.
The actual section of the code reads:
(b) Election to include in gross income in year of transfer
(1) In general
Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income for the taxable year in which such property is transferred, the excess of—
(A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over
(B) the amount (if any) paid for such property.
If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture.
An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary of the Treasury.
Mechanics of the Election
There is no form you just write (I suggest you print it out) on a piece of paper the following information:
Your name, address, and taxpayer identification number. (social security number usually)
A description of each property for which you are making the choice. (ie: options for 1000 shares of stock in XYZ, Inc.)
The date or dates on which the property was transferred and the tax year for which you are making the choice.
The nature of any restrictions on the property.
The fair market value at the time of transfer (ignoring restrictions except those that will never lapse) of each property for which you are making the choice. (this is an important number, because it and the next one will determine how much tax you pay up front. Your employer should be able to help with this number.)
Any amount that you paid for the property.
A statement that you have provided copies to the appropriate persons. (usually that is just your employer)
The statement must contain all of the information. You must sign the statement and indicate on it that you are making the choice under section 83(b) of the Internal Revenue Code. Mail the statement to the IRS at the same address you mail your tax return and to your employer. (It never hurts to use certified mail with return receipt) Keep a copy and attach it to your tax return for the year in which you make the election.
Some important things to note about an 83(b) election:
- There is a very narrow time window (30 days) in which to make the election. There is no allowance for not making the election on time.
- The value of any discount from fair market value to what you actually paid for the stock, will be reported as wages on your W-2 (or possibly 1099 if you are an independent contractor) in the year you purchase or receive the stock.
- The election is basically irrevocable. The dark side of an 83(b) election is if the expected future increase in value of your stock, does not happen for whatever reason, you still have paid tax on what could become a worthless asset and any future loss will be a capital loss which is limited to offsetting capital gains or reducing taxable income up to a maximum of $3,000 per year.