Under the IRC or Internal Revenue Code, section 83(b) offers startup founders or small business employees the option to pay taxes for restricted stock at the granting stage rate, as opposed to when stock has vested or is ready to be transferred.
Election in Details
The 83(b) election is essentially a letter sent to the United States Internal Revenue Service (US IRS) to let them know that you chose to pay tax at the rate the restricted stock shares were granted instead of the date of equity vesting.
This notification is applicable for equity that’s subject to vesting as fully vested stock is taxed at the time of grant, and it will accelerate your ordinary income tax. Tax rates occur in different types, with the maximum for regular income tax and long-term capital gains rates at 37% and 20%, respectively.
The IRS uses a system of graduated tax rates based on your income, and while you may be eligible for a lower rate, the ordinary income tax rate will be higher than for long-term capital gains. If you file a section 83(b) election and you’ve paid nothing for restricted stock, the IRS will determine your tax rate during the grant. Restricted stock is taxed at the vesting rate if you haven’t filed the election at the ordinary applicable income tax rate.
Example of Section 83(b) Election
Here’s an example of the benefits you can take advantage of when you file an 83(b) election. Say you’ve received 100,000 shares worth $0.01 at grant time, $1.00 at vesting, and $5.00 per share if you were to sell them a year later.
You are eligible for the maximum rate for ordinary income tax, as well as long-term capital gains, not taking into consideration state tax or employment tax consequences. When your shares are worth $1,000, and you file an election under section 83(b) within a month of the stock grant, you’ll pay ordinary income tax at 37%, which is $370. By selling your stock after one year from the grant date, you’ll realize a gain of $4.99 per share that’s taxable.
Your selling price won’t be $5.00 since you get income credit for the $0.01 you paid to purchase each share. Therefore, you’ll spend additional tax for economic gain at $99,800, which is the selling price of $4.99 by 100,000 shares at a rate of 20%, and the total profit after tax will be $399,830.
Significance of an 83(b) Election
There are benefits to filing a section 83(b) other than saving on the tax rate, including avoiding a $37,000 tax hit when the stock is vested. Your qualified small business stocks, as well as your long-term capital gains, are kick-started, which means you’ll receive the profits when you sell shares a year after the grant.
If the sale occurs more than five years after the grant for the qualified business stock, you’ll be entirely avoiding federal tax after meeting other conditions. It makes sense to file a section 83(b), especially if you have restricted stock that’s worth a significant amount. Filing this tax code depends on how much you received the shares for, as a share price of $1.00 instead of $0.01 per share will essentially attract thousands of tax dollars.
It’s vital, therefore, that you discuss filing an 83(b) election with your financial advisor, and you must file within the absolute deadline of 30 days after the grant. This grant day isn’t the date you received restricted stock paperwork but the instant your grant was approved by the board.
Types of 83(b) Election
With an 83(b) election, the equity you received is taxed before it is vested, which in turn accelerates your income tax, saving you money. Vesting equity, which is when it becomes transferable, is often in restricted stock form, and with this tax code, you will be taxed with a rate synonymous with the time of grant.
Filing a section 83(b) election allows you to keep a substantial part of your profits as it decreases your taxable income. To file this notification requires time-sensitivity, as the allowance isn’t available thirty days after the grant deadline expires.
However, not everyone should be running to beat the filing deadline, except if the restricted stock isn’t worth a significant amount. Filing for section 83(b) when your shares are above $1.00 per share will outrightly cost you the ordinary income tax rate of 37%, adding up to $37,000 for your 100,000 shares. Having received restricted stock at the grant date, you naturally expect it to appreciate by the time the vesting date approaches.