For founders, employees, and executives with stock-based compensation, an 83(b) election can be a powerful tax planning tool. When you make an 83(b) election, you’re opting to pay tax on unvested shares now, instead of when the stock vests. Most tax planning strategies focus on deferring tax, but an 83(b) election is all about accelerating it.
Why make an 83(b) election? The key reasons to consider an 83(b) election is to minimize taxable income and control the timing of it. If you have stock options, founders shares, or restricted stock, here’s what you should know about making an 83(b) election on unvested company stock.
What is an 83(b) election?
Section 83(b) of the tax code gives individuals the ability to accelerate the taxation of their equity grant. Typically, equity-based compensation is subject to vesting requirements: time, performance, liquidity events, perhaps multiple factors. Under default tax treatment, there are no tax implications at grant, because the taxpayer risks losing the stock until the shares are vested (or exercised in the case of options). In tax lingo, this is known as substantial risk of forfeiture.
But there are some cases when it benefits the taxpayer to recognize that income now — before the stock vests. This can be accomplished by making an 83(b) election. With restricted stock, this means paying tax on the taxable spread at grant, instead of when the stock vests. If you have stock options, an 83(b) election can be made in conjunction with an early exercise.
In either case, the gap between the exercise (or purchase) price and the current fair market value of the stock is taxable, either as ordinary income (for restricted stock and non-qualified stock options) or for the alternative minimum tax (AMT) calculation (for incentive stock options). In making the election, any subsequent taxation is deferred until the stock is sold.
Who can make an 83(b) election and for what type of stock compensation?
Startup founders, early employees, executives, and other service providers can make an 83(b) election. For stock option holders, the company must permit early exercises.
Here are the types of unvested stock compensation that are eligible for the election (assuming the shares haven’t vested):
- Restricted stock (not restricted stock units)
- Founders shares (this isn’t a legal term and is typically just common stock)
- Incentive stock options
- Non-qualified stock options
- Profits interests in an LLC or partnership
3 key benefits of an 83(b) election
In the right set of circumstances, an 83(b) election can be a very powerful tax planning tool.
1. Potential to minimize tax
As illustrated in the examples below, making an 83(b) election can drastically reduce tax in certain circumstances. An 83(b) is typically most advantageous if accelerating income when the taxable spread is at or near zero. Stock at early-stage startups usually will have a very, very low valuation, making this tax strategy possible. Assuming holding periods are met (more on this below), it’s possible to shift taxable income entirely to more favorable long-term rates through an 83(b) election.
2. Starts the clock on tax-favorable holding periods
The election starts the clock for several key holding periods:
- Long-term capital gains tax rates (0% – 20% tax rates)
- Qualifying incentive stock option sales (also long-term capital gains)
- Qualified small business stock (Section 1202) – this is especially important for founders and startups (potentially tax-free stock sales)
3. Have more control over your tax situation and equity
Another benefit of making an 83(b) election is having more control over your tax situation. Before making the election, consult your tax and financial advisor to understand the impact on your tax situation and make an informed decision.
Making the election can help avoid cash flow and tax headaches in the years to come. Without the election, restricted stock awards and early exercised stock options will have tax implications each time shares vest, as the difference between the future fair market value of the stock (less the purchase/strike price) is subject to regular income tax (this is AMT income for ISOs). For fast-growing startups, this can be a big headache, especially when there isn’t a public market for the stock.
For employees with stock options, making an 83(b) election can be important later if valuations increase. A large spread makes it very difficult financially to exercise shares before the options expire after leaving the company. It can also preclude some tax planning strategies down the road.
Tax laws change periodically, and they’re scheduled to change again in 2026. Accelerating the taxation of stock compensation might mean locking in more favorable tax rules. At the very least, it means taxpayers are less affected by financial issues outside of their control.
Considerations before making an 83(b) election
Like anything in personal finance, an 83(b) election isn’t always a no-brainer. Here are some things to keep in mind.
- The stock may not go up. The risk of filing an 83(b) election goes up with the cost to buy the shares and/or the taxable spread as you have more cash on the line. There’s a risk of over-paying tax if the valuation doesn’t go up or if the company isn’t successful.
- Your shares still need to vest. An 83(b) election is irrevocable. Make sure you’re comfortable with the vesting requirements.
- Your holding period isn’t guaranteed. Regardless of how long you want to hold the stock, M&A activity, repurchase rights, and other events can interfere.
- Cash requirements. Depending on the strike price and valuation, early exercising can still be cash intensive. Make sure it makes sense within the context of your financial situation and goals.
Simplified example: early exercising non-qualified stock options with an 83(b) election
For simplicity, the following example ignores employment taxes and state tax implications.
- Strike price = $0.1
- Current valuation = $0.1
Ordinary income at early exercise = $0. Over one year later, assume shares have vested and can be sold for $6/share. Long-term capital gain = $5.90/share.
Making the election resulted in incurring no regular income and shifting the whole gain to a long-term capital gain. The highest long-term capital gains tax rate is currently 20%.
Without the election, and still assuming an early exercise, the employee would have ordinary income of $5.90/share at vesting, regardless of whether they sold the stock. The highest ordinary income tax rate is currently 37%.
Planning notes:
- Now assume in the above example the option was exercised after vesting. In this case, the ordinary income would be the same (assuming no changes to the valuation) but the employee would control the timing. So it’s usually best to early exercise with an 83(b) election or consider delaying the exercise.
- The tax treatment in the example above is very similar for restricted stock. However, restricted stock lacks the flexibility stock options have in controlling the exercise date. With restricted stock, an 83(b) election must be filed within 30 days of the grant or the spread will be subject to regular income tax when it vests.
- Incentive stock options must be held for at least two years from the grant date and one year from vesting to benefit from long-term capital gains tax treatment. For executives with the ability to negotiate their equity compensation, other forms of stock compensation may be more favorable depending on your goals.
Long-term planning with stock compensation
If you’re a founder or if stock-based compensation is a large part of your pay package, it pays to think long-term and strategically. Especially for employees of startups, the tax and financial moves made early on are often the most crucial in generating wealth.
But it’s equally important to remain realistic about the time horizon, risk, and prospects of any one company. The decision to make an 83(b) election is just one piece of a complex puzzle that should be considered and discussed with your personal financial and tax advisors.
Article written by Darrow Wealth Management President Kristin McKenna, CFP® and originally appeared on Forbes.
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Article is for informational purposes only and should not be misinterpreted as personalized advice of any kind or a recommendation for any specific financial or tax strategy. This is a general communication should not be used as the basis for making any type of tax, financial, legal, or investment decision.
Last reviewed July 2024
