What is a Section 83(b) Election?

Section 83(b) Election tells the Internal Revenue Service (IRS) that you want to report income tax the year your stock was granted instead of when it is vested. This means you will report income at the current stock price when the stock is granted to you instead of the stock price the year the stock vests.

Entrepreneurs grant themselves stock in the companies they start, and often offer their employees and contractors some form of equity incentive (e.g., stock of corporations or membership units of LLCs) to entice them to come on board.  If you’re considering granting stock to yourself as a founder or joining a company that’s offering to grant you stock in addition to or in lieu of a paycheck, you should understand the potential tax consequences before accepting.

The IRS views an equity grant as a form of taxable compensation, and if you’re the recipient of such a grant, you will be taxed on its fair market value at the time the stock was granted.  If the stock is granted free and clear of any restrictions (as opposed to vesting over time), the tax consequences are fairly straightforward.  Let’s say a founder is granted 10,000 shares of stock worth .50 cents per share at the time it was given. He or she will owe the government tax on the value of the stock, which in this case is $5,000.  If their income tax rate is 30%, that amount will be $1,500.

The Benefit of Vesting

One of the primary purposes of an equity grant is to encourage founders and new employees to stay with the company for as long as possible.  Simply giving out stock free and clear defeats that purpose, because a founder or employee has no incentive to stick around.  If you give 10,000 shares to an employee, he or she can quit after a month, and take the stock with them.   If it later goes up to $10 per share, the ex-employee can cash out at $100,000, which is not bad for a month’s work.

This is why most if not all equity grants come with vesting provisions, in which rights in the stock vest over time.  Let’s go back to the case of the fictional employee who was granted 10,000 shares of stock worth .50 a share.  In this example, the stock comes with a vesting schedule of 2,500 shares at the end of each 12-month period following the grant date.  If the employee leaves the company during the course of that 12-month period, the shares are forfeited.  Now the employee has an incentive to stay with the company for at least four years.  Let’s assume that the value of the shares is $3.00 per share at the end of year one, $10.00 at the end of year two, $15.00 at the end of year three and $20.00 at the end of year 4.

Potential Tax Consequences

This is where the employee may run afoul of Section 83(a) of the Revenue Code.  Under this section, if any equity grant is not transferable or is subject to a substantial risk of forfeiture, it will be taxable at the fair market value of the shares as of the respective vesting dates, and not the grant date.  At a 30% tax rate, the employee may have a problem.    Here’s what happens in the form of a table:

Period

Vested Shares

Value Per Share

Taxable Income

Tax Owed

Year one end

2,500

$3.00

$2,500

$750

Year two end

2,500

$10.00

$25,000

$7,500

Year three end

2,500

$15.00

$37,500

$11,250

Year four end

2,500

$20.00

$50,000

$15,000

 

 

TOTALS

$115,000

$34,500

 

Thanks to Section 83(a), our hapless employee granted vesting shares is stuck with a tax bill totaling $34,500.   So how can a founder or an employee with a vesting equity grant avoid this unhappy result?  By filing an election with the IRS pursuant to Section 83(b) of the tax code.

The 83(b) Election:

Under Section 83(b), the employee in our example is permitted to make a so-called “Section 83(b) election.” If the election is made, the employee will be required to recognize as income the fair market value of all of the granted shares as of the date of grant, rather than the date of vesting.

In our example, the fair market value of the 10,000 shares on the date of grant is $0.50 per share, and the resulting income is $5,000.  With an effective federal income tax rate of 30%, the employee will pay a total of $1,500 in federal income tax as a result of the grant and Section 83(b) election.  Note that this is more than twice the amount the employee would have owed for the first year had the election not been made.

By taking the 83(b) election, the employee has essentially decided to pay more in taxes up front based on the hope that the value of the stock will rise significantly during the vesting period, which would result in an overall tax savings.   Thanks to the 83(b) election, the annual vesting will not be treated as a taxable event, and when the stock is sold, any appreciation since the grant date will be taxed as a capital gain as opposed to ordinary income.

The Downside:

Once it’s taken, the 83(b) election is irrevocable. If an employee makes the election and pays full tax on the shares as of the date they’re granted, and he quits or is fired during the vesting period, he forfeits all of his unvested shares, and will not be entitled to get a refund of any tax paid.  Another risk when dealing with a startup is the very real chance that it may not succeed.  If the company goes under after a year or two, you’ve paid tax on stock that is now worthless.  

The stock may also go down in value.  For example, if an employee takes the 83(b) election on a grant of 10,000 shares valued at $10 per share that vest over four years, he’ll owe $30,000 in taxes that first year.  Let’s say he or she stays with the company over the course of the vesting period, and the stock price sinks to $1.00 per share. Thanks to the 83(b) election, that employee has paid significantly more taxes than he or she would have otherwise been responsible for absent the election.

Clearly, this downside is more likely to be encountered in the case of an established company.  In contrast, startups generally have low-value equity, especially if they’re pre-revenue or not yet profitable.  Because the market value of startup stock is extremely low (sometimes less than a penny a share), the Section 83(b) election for unvested stock in such a startup is generally very low cost and may not trigger any tax due.

How to Take the Election

Founders and employees desiring to take a Section 83(b) election must do so within 30 days of the grant.  Failure to do so waives the election, so startup founders and employees must always keep that strict deadline in mind.  

To file the election, one need only complete the Section 83(b) election form and mail it to the IRS within 30 days after the equity is granted.   The IRS has prepared a sample form, which is available here, and forms for both corporations and LLCs are available on the UpCounsel site.

When not to Take the Election

You should consider not taking an 83(b) election if any of the following circumstances apply to your situation:

  • You are given an outright grant of fully vested stock with no restrictions;

  • You purchased stock at its fair market value;

  • You were granted stock options and you don’t exercise them early;

  • The price of the stock is relatively high, and you would incur a significant tax bill by filing the 83(b) election that you can not pay;

  • You believe the stock price may go down;

  • You believe the company may fail before your stock vests; or

  • You believe you might forfeit your stock;