Section 83(b) Election
A Section 83(b) election is a tax election that allows employees or service providers who receive restricted property, such as stock, in connection with the performance of services to include the value of the property in their gross income at the time of transfer rather than when the property becomes vested. This election can be particularly relevant for startups, where equity compensation is a common practice. Below, we explore the pros and cons of making a Section 83(b) election, the process of making the election, the tax implications, and examples of when it might be beneficial or detrimental.
Pros and Cons of a Section 83(b) Election
Pros:
- Tax Savings on Appreciation: By making a Section 83(b) election, the recipient can lock in the current fair market value of the property as taxable income. Any future appreciation in the value of the property will be taxed as capital gains rather than ordinary income, which typically has a lower tax rate.
- Long-Term Capital Gains: If the property appreciates significantly, the recipient can benefit from long-term capital gains treatment if they hold the property for more than one year after the election.
- Predictability: The election provides certainty regarding the amount of income to be reported and the timing of the tax liability, which can aid in financial planning.
- Immediate Tax Liability: The recipient must pay taxes on the fair market value of the property at the time of transfer, even if the property is not yet vested and may be forfeited.
- Risk of Forfeiture: If the property is forfeited before it vests, the recipient cannot recover the taxes paid on the initial inclusion of income.
- Cash Flow Issues: The recipient may face cash flow issues if they have to pay taxes on property that has not yet provided any liquidity.
Process of Making a Section 83(b) Election
Steps to Make the Election:
- Timing: The election must be made within 30 days of the transfer of the property. This deadline is strict and cannot be extended.
- Filing the Election: The recipient must file a written statement with the IRS. The statement must include:
- The name, address, and taxpayer identification number of the recipient.
- A description of the property with respect to which the election is being made.
- The date or dates on which the property was transferred and the taxable year for which the election is being made.
- The nature of any restrictions on the property.
- The fair market value of the property at the time of transfer.
- The amount paid for the property, if any.
- A statement that copies have been furnished to the appropriate persons as required by the regulations.
- Submitting the Election: The election must be filed with the IRS office where the recipient files their return. Additionally, a copy of the election must be attached to the recipient's income tax return for the year in which the property was transferred.
- Providing Copies: The recipient must provide a copy of the election to the person for whom the services were performed (e.g., the employer).
New IRS Form:
The IRS has introduced Form 15620, “Section 83(b) Election,” which standardizes the process and reduces the risk of filing errors. This form can be used instead of drafting a custom election statement [7].
Tax Implications
Inclusion in Gross Income:
Under Section 83(a) of the Internal Revenue Code (IRC), the recipient must include in gross income the excess of the fair market value of the property over the amount paid for the property at the first time the rights to the property are either transferable or not subject to a substantial risk of forfeiture [1].
Election under Section 83(b):
If a Section 83(b) election is made, the recipient includes in gross income the fair market value of the property at the time of transfer, minus any amount paid for the property. This inclusion occurs in the taxable year in which the property is transferred, regardless of whether the property is substantially vested [1].
Basis and Holding Period:
The basis of the property is the amount paid for the property plus the amount included in gross income under the Section 83(b) election. The holding period for capital gains purposes begins just after the date the property is transferred [1].
Examples of When a Section 83(b) Election Might Be Beneficial or Detrimental
Beneficial Scenario:
Example 1: Alice receives restricted stock in a startup valued at $1 per share, with the potential to appreciate significantly. She makes a Section 83(b) election, including $1 per share in her gross income. Two years later, the stock is worth $10 per share. By making the election, Alice pays tax on the initial $1 per share and benefits from long-term capital gains treatment on the appreciation from $1 to $10 per share when she sells the stock.
Detrimental Scenario:
Example 2: Bob receives restricted stock in a startup valued at $5 per share. He makes a Section 83(b) election, including $5 per share in his gross income. However, the startup fails, and the stock becomes worthless. Bob cannot recover the taxes paid on the initial $5 per share inclusion, resulting in a financial loss.
Conclusion
A Section 83(b) election can be a powerful tool for employees and service providers in startups, allowing them to lock in the current value of restricted property and potentially benefit from lower capital gains tax rates on future appreciation. However, it also carries risks, including immediate tax liability and the potential for forfeiture. Careful consideration and planning are essential to determine whether making a Section 83(b) election is the right choice based on individual circumstances and the specific terms of the equity compensation.
For more detailed guidance, taxpayers should refer to the relevant sections of the Internal Revenue Code (IRC) and IRS guidelines, including IRC Section 83 and Treasury Regulations, as well as consult with a tax professional.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
