The Section 83(b) Election: An Important Tax Strategy

Business Tax

Prior to discussing what the Section 83(b) election is, it is important to develop a basic understanding of how the Internal Revenue Service (IRS) taxes property transferred in connection with the performance of services under Section 83 of the Internal Revenue Code.

The IRS enacted Section 83 as part of the Tax Reform Act of 1969. Section 83 established a concrete time frame in which restricted property must be included in income. The value of property transferred in connection with the performance of services is includiblein an employee’s gross income upon the earlier of the following events:

  • The date on which the employee’s rights in the property are not subject to a substantial risk of forfeiture, or
  • The date on which the employee’s rights in the property become transferable.

Substantial risk of forfeiture exists with regards to restricted stock that is subject to a period of eligibility, typically a vesting schedule. An employee generally vests in stock subsequent to continued employment for a specified period of time, or attains specific performance metrics. Vesting may occur over one year, or several. Transferability exists when the employee may transfer the stock to a third party, and such third party may obtain the stock on a fully vested basis. However, transferability rarely exists without elimination of substantial risk of forfeiture. Therefore, it is important to understand the vesting schedule.

The gross income realized by the employee upon vesting is treated as compensation. Section 83(a) calculates includible gross income as follows:
Fair market value (FMV) of such property on the date the employee vests, over the amount (if any) paid for such property.
On that date, the employee’s holding period begins and the basis in such property is equal to the amount of consideration paid plus any amount includible in gross income. Additionally, any subsequent appreciation or depreciation of value in the stock is treated as a capital gain or loss.

To summarize, Section 83 applies to property transferred in connection with the performance of services. The property becomes includible in gross income on the date it is either not subject to substantial risk of forfeiture or is freely transferable. The amount includible is determined by the fair market value on that date less the amount paid for the property, if any. The character of the income recognized is ordinary and treated as wages subject to payroll taxes.

Now that we have a basic understanding of Section 83, let’s explore the Section 83(b) election.

Making the Section 83(b) Election

Rather than wait until vesting, an employee may elect to report in income, the excess of the FMV of the restricted stock over consideration paid in the year the stock is granted. This election is called the Section 83(b) election (election).

There are a few things that employees and tax advisers must be aware of. First, when an employee decides to make an election, the election must be filed with the IRS no later than 30 days after the date the property was transferred. The election is made by filing one copy of a written statement with the Internal Revenue office with which the employee files his income tax return, and attaching one copy of such statement directly to the employee’s income tax return for the taxable year in which such property was transferred.

In addition to the aforementioned filing requirements, the employee must also submit a copy with his employer. It is especially important to file a copy of the election with the employer as the employer is entitled a deduction under Section 83(h) in the amount of gross income reported by the employee. Lastly, the election must contain specified language.

On the date the election is made, the employee must include the excess of the FMV over consideration paid for the restricted stock transferred. The income is includible in the taxable year in which the employee made the election as ordinary income. As mentioned above, the employee’s basis in the restricted stock is the amount includible in gross income plus any consideration paid. Additionally, although the employer remains owner of the property in the eyes of the IRS, the holding period for such stock begins on the date it is transferred to the employee.

As the employee meets the vesting requirements of the restricted stock, no income recognition is necessary. All appreciation in the stock through the date of vesting is “tax deferred” until the stock is sold. The character of the gain upon sale, if any, will be either short-term or long-term capital gain depending on the holding period. This is a distinct advantage of the Section 83(b) election.

To illustrate, restricted stock granted to an employee of a start-up and emerging growth technology company will initially be granted at a low valuation. Therefore, the amount of gross income the employee will be required to recognize on his individual income tax return will typically be much lower than when the stock vests later on.

There are two distinct situations that are disadvantageous to employees that make a Section 83(b) election. Should the value of the stock decrease after the election is made, any loss recognized upon the sale would be a capital loss and potentially limited to$3,000 per year on the employee’s individual income tax return. If the employee does not meet the vesting requirements and ultimately forfeits the restricted stock, the employee may only realize a loss equal to the excess of the amount paid for such stock over the amount realized upon such forfeiture. Generally, employees will receive restricted stock at no cost; therefore, the loss permitted to them is zero. In addition to realizing no loss, the employee is not entitled to recover any of the taxes paid in the year the election was made.

Conclusion

In summary, the 83(b) election provides for potential tax savings, both up-front and in total. Despite the temptation of potential tax savings, the employee should consider the following:

  • Will the employee remain employed with the company? Will he meet the performance metrics throughout the vesting period?
  • Does the employee expect that the performance of the company is favorable for increased stock valuations?
  • At the time of grant, will the employee be able to afford to pay the tax liability in the year of the election based on the valuation?

After considering the above, an employee will be able to make an educated decision as to whether or not the benefits of the 83(b) election will come to fruition.

The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals.

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