83b Election on Stock Options

Folks with stock options often have their employers present them with an 83b election option. What is a Section 83b election and should you file one?

​An 83b election is a letter you send to the IRS informing them of your choice to be taxed on your stock options (like RSU’s) on the grant date rather than vesting date. This has you facing ordinary income tax at an earlier date, but can help lower your taxes in the long term.

With certain stock options like RSU’s, you pay taxes at two different points: 1) when you are granted or exercise stock, and 2) when you sell the stock. The first tax is based on the discount you receive on your purchase of the stock, and is taxed at ordinary income rates, which are generally the highest tax rates. The second tax that occurs when you sell, is based on any growth in the stock while held and is subject to capital gains rates (assuming you hold the stock for at least one year). Capital gains rates are lower than ordinary income rates.

So by filing the 83b election, you’re hoping to pay more taxes at the capital gains rate versus ordinary income tax rates. This is best illustrated through the following examples that assume you receive 10,000 shares (at no cost to you) worth $.50 per share at grant time, $2 per share at vesting time, and $7 per share at sale time (at least one year after acquiring the stock). The examples also use 32% ordinary tax rate and 15% capital gains tax rate assumptions.
 
Scenario #1 (with 83b election):
In this scenario, you’d pay ordinary income tax of $1,600 ($5,000 grant value minus $0 cost for shares, times 32% ordinary income tax rate). Because of your 83b election filing, you pay the above taxes at time of grant and not when the stock is vested/exercised. You’ll then pay taxes again on the sale at capital gains rates (assuming 1 year holding period). This gain of $6.50 per share ($7 sale price, minus $.50 grant value) would result in a tax of $13,000 (10,000 times $6.50, times 20%). So your net profit would be $55,400 ($70,000 sale, minus $1,600…minus $13,000).
 
Scenario #2 (no 83b election):
In this scenario, you don’t file an 83b election, so you pay no taxes at the time of stock grant. Instead, you pay ordinary income taxes on the income at time of vesting/exercise. This tax would be $6,400 ($20,000 vest value minus $0 cost for shares, times 32% ordinary income tax rate). You then pay capital gains taxes on the gain of $5 per share ($7 sale price, minus $2 vest value), which means a tax of $10,000 (10,000 times $5, times 20%). So your net profit in this example would be $53,600 ($70,000 sales, minus $6,400…minus $10,000).
 
*So with the 83b election in this example, you saved nearly $2,000 overall.
**The 83b election also allowed you to pay less taxes at a time when you didn’t yet have the proceeds from the sale, since you were able to pay more of the taxes after the stock sale rather than at time of vesting.
 
So why is there even an option to file this election? Why isn’t it automatic if it’s so beneficial?
While it almost always makes sense to file the 83b election, there are times when it doesn’t pencil out. For instance, in the case where the stock you receive is worth much more at time of grant, this would result in you immediately owing a larger tax than you may be comfortable paying, especially if the company later goes under before your stock vests, as you would be better off not paying these taxes upfront without the later savings on a losing stock.
 
So it’s ultimately a bet on a rising stock with a lower initial value. The better you think the company will do, the more the election makes sense.
 
NOTE: you must file the election with the IRS within 30 days of your stock grant. Your employer should guide you through this.