Employee stock grants can be an excellent benefit, but they can also be complicated, especially when they involve restrictions and vesting schedules. Stock grants also come with significant tax consequences that, depending on the situation, can leave you with large tax bills. However, you do have some control over when those tax bills are paid and, in the right circumstances, you can lower your total tax bill significantly if you elect to pay taxes upfront. That’s where the 83(b) election comes in.
When a company awards an employee restricted stock, the employee is taxed on the difference between what they paid for the stock and the fair market value of the stock. For example, if an employee is awarded stock worth $10 and the employee paid $8 for the stock, the employee is taxed on the difference of $2. Typically, the employee isn’t taxed on that $2 until they actually become vested in the stock. Until then, the stock is at substantial risk of forfeiture because if they leave the company for any reason, they won’t receive the stock.
Basics of an 83(b) election
With an 83(b) election, you are electing to pay taxes on the entire value of the stock on the date of grant instead of paying taxes as you become vested in the stock. You pay taxes based on the current value as opposed to whatever the value happens to be when you become vested.
For example, you are awarded 10,000 shares of company stock that vest over 5 years. The current share price is $1. If you make the 83(b) election you will include $10,000 in your ordinary income the year you are granted the stock and you will be taxed at your marginal tax rate. This could be up to 40% which means $4,000 in taxes for those in the higher tax brackets. If you don’t make the 83(b) election, you will include in your ordinary income each year the portion that vests that year. The example below assumes 20% vesting each year and 40% tax withholding.
|Stock Price||Vested Value||Taxes Due|
|Grant||$1.00||$ –||$ –|
|Year 1||$1.50||$ 3,000.00||$ 1,200.00|
|Year 2||$2.00||$ 4,000.00||$ 1,600.00|
|Year 3||$2.50||$ 5,000.00||$ 2,000.00|
|Year 4||$3.00||$ 6,000.00||$ 2,400.00|
|Year 5||$3.50||$ 7,000.00||$ 2,800.00|
What are the benefits of making the 83(b) election?
In the example above, if you made the election, you would have paid $4,000 in taxes at the date of grant. If you didn’t make the election, you would end up paying $10,000 over 5 years. The more the stock price goes up, the more money you save on taxes by making the 83(b) election.
What are the risks of making the 83(b) election?
If you leave the company before you are fully vested in the stock, it’s possible you will have paid taxes on stock that you don’t ultimately receive. In the above example, if you left after 2 years you would have overpaid by $1,200; however, if you stayed at least through year 3 you would come out with tax savings.
If the stock price declines you would also end up overpaying on taxes.
When would I want to make an 83(b) election?
- You plan on staying at the company until your shares are fully vested;
- You have the cash to pay the taxes due within 30 days of your stock grant;
- You are confident that the value of the stock is going to go up;
- Adding the vesting value to your income each year would; consistently make you ineligible for tax credits that you would otherwise be eligible for;
- Your tax bracket will be the same or higher in future years.
When wouldn’t I want to make an 83(b) election?
- You plan on leaving the company before the stock is fully vested;
- You don’t have enough liquid assets or it would strain your finances to pay the taxes upfront;
- You think the stock value will go down or stay the same; or
- You will be in a lower tax bracket in the year(s) the shares vest.
What happens when I sell the stock?
You will pay the favorable capital gains tax rate (20% + 3.8% for high-income taxpayers) on any amount that exceeds your cost basis.
If you make the 83(b) election, the cost basis in our example would be $1 per share because that is the amount you included in your income. If you sold all your shares in year 5 after becoming fully vested you would have a capital gain of $25,000. ($35,000 sale price – $10,000 cost basis)
If you do not make the 83(b) election, the cost basis of your shares would vary based on the price of the stock as it vested. You would have a total capital gain of $10,000.
|# of Shares||Cost Basis||Capital Gain|
|Year 1||2000||$ 3,000.00||$ 4,000.00|
|Year 2||2000||$ 4,000.00||$ 3,000.00|
|Year 3||2000||$ 5,000.00||$ 2,000.00|
|Year 4||2000||$ 6,000.00||$ 1,000.00|
|Year 5||2000||$ 7,000.00||$ –|
Your total taxes paid after the sale of all shares:
|83(b) election||No 83(b) election|
|Ordinary Income (40% tax rate)||$ 10,000||$ 25,000|
|Capital Gains (23.8% tax rate)||$ 25,000||$ 10,000|
|Total Taxes Paid||$ 9,950||$ 12,380|
An 83(b) election can be an effective tool to potentially lower your overall tax liability on employee stock grants; however, there are many factors that go into determining if it’s the right choice for you. How a company sets up its stock plans and each employee’s situation can vastly impact these numbers and introduce other considerations that might make an 83(b) more or less appealing. As financial professionals, it’s our job to help guide you through the options and determine the best course of action for you and your unique situation.
Alicia Vande Ven, M.S.
Candidate for CFP® Certification
Alicia Vande Ven is a Candidate for CFP® Certification at Walkner Condon Financial Advisors, a fee-only, fiduciary financial advisor firm based in Madison, WI, that works with clients locally and around the country.