Making a Section 83(b) Tax-Reduction Election
When an executive gets restricted stock, it is usually not counted as income. But the executive can choose to count the compensation as income when they get it. The amount counted as income is the difference between how much the stock was worth when the executive got it and how much, if anything, he or she paid for it. Taxes on income and wages are taken out of this money and paid. People often call this type of election a Section 83(b) election.
83(b) Election Tax Consequences
Section 83(b) allows the executive to:
Avoid Stock Vesting Income
By making Section 83(b) election, stock vesting is tax-free (i.e., when the stock is no longer subject to a substantial risk of forfeiture and is readily transferable). Any stock appreciation between the transfer and vesting dates isn’t recognized until the stock is sold.
Future Appreciation Becomes Capital Gain
The election determines the executive’s ordinary (compensation) income upon receiving stock. This is the difference between the stock’s transfer date value and the purchase price. Even though the executive pays full price with no bargaining, the election can still be used. Any stock appreciation is taxed as capital gain when sold. Income recognition starts the executive’s holding period.
Assume Stock Ownership
The executive is treated as the restricted stock owner for federal income tax purposes if Section 83(b) is elected. Therefore, stock dividends are not considered compensation income.
The Section 82(b) election means the executive must recognize compensation income on the date of transfer but receives no cash to pay the transfer tax. If the executive forfeits the stock (i.e., fails to meet the terms and conditions), he or she cannot deduct the previously recognized income. Elections involve risk.
When to Use the Section 83(b) Election
Section 83(b) election is appropriate when:
- At transfer, shares have nominal value. Executives make the choice when the shares have a nominal value at the transfer date, such as founders’ stock.
- Executive buys stock at full or near-full price. The Section 83(b) election is allowed even if the executive pays full or substantial FMV. When Section 83(b) is elected, little or no income is recognized, and all subsequent appreciation is treated as capital gain.
- Between receipt and substantial vesting, the stock’s value may rise significantly. By electing Section 83(b), the executive does not have to include in income any appreciation of the stock between the date of transfer and the date of vesting. When the stock is sold, this appreciation is taxed as capital gain.
When not to hold the election:
In the following situations, it may not be a good idea to make the Section 83(b) election:
- The executive must report substantial income upon receiving the stock.
By electing Section 83(b), the executive must report as income the difference between the stock’s FMV and the amount paid at receipt. If the stock’s market value is high and the executive pays a small amount, a large amount of compensation income will be recognized up front with no cash to pay the tax. Section 83(b) election is generally not appropriate unless significant future stock appreciation is expected and the executive is confident the stock will vest.
- The stock’s value won’t change significantly.
If stock value stays the same, the executive reports income sooner. If the stock declines, the executive has reported income sooner and more than needed. If the stock’s value drops, no deduction is available for the income recognized on its receipt when Section 83(b) was elected. Only a capital loss based on the executive’s stock purchase price is allowed.
- The executive may not meet the conditions, creating a forfeiture risk.
If an executive fails to meet the conditions creating a substantial risk of forfeiture, he or she cannot deduct income recognized under the election. Instead, only a capital loss based on the executive’s purchase price is allowed. If the executive may lose the stock, the election should not be made.
When receiving restricted stock with a nominal value or when paying full or substantial value for the stock, a Section 83(b) election should be made. In these cases, the election has little downside risk because little or no income is recognized up front.
The more difficult situation is when substantial compensation income must be recognized up front as a result of the Section 83(b) election and it is unclear whether future stock appreciation will justify early recognition. Decision-making factors include:
- Nature, timeline, and likelihood of executive compliance.
- Current and future ordinary income and capital gains tax rates.
- Carryover use and expiration likelihood.
- The stock’s actual and estimated FMV upon receipt, vesting, and sale.
Due to many variables, the practitioner should project after-tax cash flow with and without Section 83(b).
Section 83(b) election must be made before or 30 days after share transfer. The taxpayer must file the election statement with the IRS Service Center where the tax return will be filed. The taxpayer must also give his or her employer a copy of the election so it can claim the deduction. The company should acknowledge the election.
This election has only 30 days. The election should be considered in advance.
Section 83(b) election can be revoked within 30 days of making the election. Only the IRS can revoke a Section 83(b) election. If the executive is mistaken about the transaction, consent will be granted. The executive must request revocation within 60 days of discovering the error.
Mistakes about the stock’s value or decline, failing to perform an act contemplated at the time of the stock transfer, or failing to understand the tax consequences of the election are not mistakes of fact.