If you’re making a large sum of ordinary income while investing, you’re in a unique tax situation. Ordinary income, like what you earn on through your W-2, on a Form 1040 income is highly taxed. But if you use the right methods to handle your investment income, you can save a lot of money.
If you’ve acquired restricted stock options, you should consider the Section 83(b) election form.
A Section 83(b) election form is an investor-specific form that may be in your interest to fill out if you want to accelerate your ordinary income tax. If you’ve invested in or received founder's stock, you are eligible for the election. But there are a few other situations where you should want to file this form as it could save you a lot of money.
There is some confusion as to what exactly the form implies and whether it makes sense to file. In this guide, we’ll go over both of those questions.
What Exactly Is The Section 83(b) Election?
A Section 83(b) election is a form you send to the IRS. It lets the IRS know that you want to be taxed on your equity on the date it was granted to you, and not on the date your equity vests.
You do not need to fill out the Section 83(b) election unless you purchased restricted stock options. Any options you hold that have restrictions are applicable. And if you did acquire a restricted stock, especially in a growing company, filing the election can save you a lot of money.
As an example, imagine you own 25% of the stock in your startup. You acquired 100,000 shares at the beginning of the tax year: January 1st, 2019. Its fair market value was $10,000 when it was granted ($0.10 per share).
Being timely, you filed a Section 83(b) election within 30 days of the restricted stock grant. Your stock is worth $1 per share when it vests. Now your ordinary income tax would have been $37,000 ($100,000 x 37% short-term capital gains tax). But because you were fast and filed the 83(b) election, you don’t need to pay tax when your stock vests. You only need to pay when you sell it.
More than one year after the grant, you feel it’s time to sell your stock. It’s now worth $5 per share for a total of $500,000. Your tax burden is $98,000 ($490,000 x 20% long-term capital gains tax). You get a credit for $0.10 per share ($500,000 - $10,000) you already included in income.
The Consequences Of Not Filing
Now, if you had opted to NOT file a Section 83(b) election, you would also be taxed for “phantom income” as your company grows.
So, if your company grows and the value of your stock grows alongside it, your phantom income tax burden also grows. On top of the long-term capital gains tax you pay on the sale, you also have to pay ordinary income tax when your shares vested. Say your stock is worth $100,000 when it vests, your ordinary tax burden is $37,000 ($100,000 x 37% ordinary income tax) when the shares vest.
Now, you still have to pay long-term capital gains taxes (20%) when you sell your stock at least one year after the grant date. You will be credited for the income you already took in when your stock vested.
In this scenario, it is time to sell your stock, and the shares are valued at $4 per share for a total of $400,000. You will pay long-term capital gains tax of $80,000 ($400,000 x 20%) in addition to the $37,000 of ordinary income tax you paid when the shares vested for a total tax burden of $117,000.
In the example we just went over, not filing an 83(b) election would lead to a significantly higher tax bill. Filing the election would have eliminated the need to pay taxes on your phantom income.
What Is Phantom Income?
Phantom income, or “phantom revenue,” is money that you never receive but are still taxed on. The term is typically applied to investment gains that haven’t yet been realized through either sales or distributions.
Phantom income from your stock, such as in the example above, can be avoided with a Section 83(b) election. The election notifies the IRS that you, the elector, have opted to report the difference between what you originally paid for your stock and the stock’s fair market value as taxable income today.
So, the value of your shares during their vesting period won’t matter. You won’t have to pay additional taxes for them until you sell them.
Why Should I File An 83(b) Election?
There is only one result that makes filing an 83(b) election worthwhile, and in the end, it can save you a lot of money.
If a taxpayer files the 83(b) election, they can pay taxes on their equity before the vesting period begins. In the case you file the form, the value of your shares during their vesting period won’t be subject to additional taxation and you’ll be able to retain your vested shares later. Just keep in mind that if you sell your shares, you will still be subject to capital gains taxes.
As you can see, it makes the most sense to file the election if you are sure the value of your shares will go up. In the case of a fast-growing startup, an 83(b) election will save you the most money. You’ll then only be taxed on the book value of the shares you acquired at the time you acquired them.
The tax savings this will produce for you is considerable. Your phantom income will not result in phantom taxation going forward.
The examples and benefits we’ve discussed all assume that the value of your stock increases. But what if the value of your company consistently declines? What does an 83(b) election mean for you?
Ultimately, if you file an 83(b) election and your stock declines, you’re at a loss. The fact you elected to pay tax on your equity means that you overpaid in taxes by paying early on a higher equity valuation. You will then have paid taxes for your stock based on the fair market value as of the grant date.
A short-term decline in your stock value won’t necessarily mean you’re at a loss. But if your stock value fails to surpass its fair market value at the grant date, you’re at a loss. Filing an 83(b) election is a long-term tax plan, and ultimately a risk if you’re unsure that the company will succeed.
Another potential downfall of an 83(b) election is the risk of stock forfeiture. If you leave the company before the vesting period is underway, you lose the benefits of your early taxation. There is no tax refund for the taxes you’ve already paid if you leave early.
How To File A Section 83(b) Election Form
If you’re thinking of filing an 83(b) election, you should first make sure you’re eligible.
The first important factor to note is that you must file your election within 30 days of the grant date of your restricted stock. If you don’t file within this time limit, your election will be voided.
Next, you must also send a copy of your completed Section 83(b) election form to the company. You must include your annual tax return with the submission of your election.
Submit The Documents
You must submit the following documents to the IRS:
The original completed and signed copy of your Section 83(b) election form
A self-addressed and stamped return envelope
You will have to mail the documents to the address where you would normally file your tax returns. Be sure to verify your address on all documents.
You will have to send one copy of the completed election form to the company, the IRS, and in some states, you will also be required to send a copy of the completed election form with your state income tax returns. Lastly, you should keep one completed copy for your own personal records.
Consult A Professional
You should consult your tax advisor when trying to file a Section 83(b) election. Filing the form properly is important and mistakes can cause you to miss your 30-day deadline. Furthermore, a tax professional can ensure you meet your state’s personal income tax return requirements as well.
Have your tax advisor walk you through the 83(b) election process. That way you can also ask them about any concerns you have regarding your future tax liability and your restricted stock. If you would like to consult with Cerebral Tax Advisors, please use this link to book a Tax Discovery Session with us!